4A. The World Bank’s Response to the Latin America and East Asia Crises
The Mexico crisis of 1994 and its so-called Tequila effect and the more recent East Asia financial crisis have presented a challenge for international organizations responsible for international financial intermediation.1 The challenge was made more demanding by the suddenness with which the crises developed and the large financing packages that needed to be put together to stabilize the situation.
I will deal first with the World Bank’s response to each one of these crises and then I will touch briefly on the lending instruments used as part of this response and some of the policy issues that the institution faced in preparing its response.
Origin of the Latin American Crisis: Mexico
The crisis started in Mexico, precipitated by a series of domestic and external shocks. While 1994 should have started off with a celebration in Mexico as the North American Free Trade Agreement went into effect on January 1, that day turned into a nightmare for the government as guerrillas surprised the nation and the world by seizing six towns in the impoverished southern state of Chiapas. More social and political turmoil followed during the intensely political year dominated by the campaign for the presidency.
At the time, Mexico was running up an unsustainable current account deficit. The years 1990–93 were years of great optimism and expansion. The government had successfully stabilized the economy and had opened it up to the outside world. A tremendous private credit boom ensued as foreign money poured into the economy. In the period 1991–93, net private capital flows to Mexico amounted to $43 billion, far more than to any other Latin American country.2 The successful conclusion of the NAFTA negotiations and Mexico’s accession to membership in the OECD in April 1994 testified to the country’s new-found high international standing. There was, however, a downside to the boom. The peso became overvalued, which hurt export competitiveness and contributed to the worsening current account deficit. In order not to frighten off foreign investors, the Secretary of Finance had publicly disavowed the possibility of a currency devaluation. Problems accelerated when the U.S. Federal Reserve raised interest rates on five successive occasions, which substantially slowed the inflow of U.S. portfolio investment. The government responded by drawing down international reserves and by sharply increasing its borrowings in peso-denominated, but dollar-indexed, short maturity notes (tesobonos). The growth in the volume of these notes was astonishing: from about $8 billion in February 1994 to about $82 billion in November.
In the face of growing concerns about the financial and social-political situation, especially after the murder of the secretary-general of the ruling party in September 1994, both Mexican and foreign investors started to transfer their money out of the country. The tesobonos market dried up as investors were no longer willing to carry the sovereign risk on these obligations at rates acceptable to the Mexican authorities. Eventually, in December, just a few weeks into the presidency of Ernesto Zedillo and with a new secretary of finance, the government decided to broaden the band within which the peso was allowed to float. It was too little too late and a chain-reaction financial panic ensued. The peso was allowed to float, and its fall was not stemmed until February/March 1995 when the government was able to announce a strong program of fiscal and monetary adjustment and a $50 billion bilateral and multilateral rescue package.
The Bank’s Response
As part of the international rescue package, the World Bank contributed about $2 billion in loans during calendar year 1995. The program financed by these loans focused on commercial banking and financial sector reform, health, nutrition, education, and privatization.
The financial sector was severely impacted by the peso devaluation and the recession that followed. But even before the crisis, the banking system suffered inherent weaknesses. The commercial banks, which had been nationalized 10 years earlier, were reprivatized in 1992. Between 1992 and 1994, they recorded significant growth in deposits and even greater growth in loan portfolios. However, lending procedures were inadequate and government oversight was lax, with the result that the quality of loan portfolios was poor, loan-loss provisions were inadequate, and capital adequacy ratios and profitability were overstated. The adverse effects of the devaluation were swift and severe: the banks incurred significant foreign exchange losses, their investment portfolios (which consisted mainly of fixed-income securities) were seriously impaired by the dramatic rise in interest rates, they came under heavy liquidity pressure, and deterioration in the quality of their loan portfolios accelerated dramatically.
With the Bank’s assistance, the government put together a restructuring program that focused on the provision of liquidity, recapitalization, diagnostic studies of banks that had to be reorganized, preparation of bank restructurings, design of a debt restructuring mechanism for private debtors, and policy and institutional reforms. Among the principal reforms, particularly noteworthy were the improvements in banking supervision, revision of accounting standards and disclosure requirements, tightening of prudential regulations, review of the deposit protection system, and modernization of the regulatory framework for lending and securitization. The Bank gave another strong boost to the development of the domestic capital market by assisting the government in the progressive privatization of its social security system for private sector employees.
The Bank made a significant contribution to protecting the poor in the immediate aftermath of the crisis. A loan for essential social services supported high priority social programs in basic education, basic health, retraining and employment generation, and nutrition. It also financed improved measures to monitor social sector expenditures, thus laying the foundation for increased efficiency. Another loan for basic health care services specifically targeted the 11 poorest states.
Argentina: The Tequila Effect
Argentina was hit hard. At the time of the Mexico crisis, Argentina was enjoying an import boom, financed by foreign direct and portfolio investment. The so-called tequila effect was straightforward: investors shaken by the rapid collapse of the Mexican economy withheld further investment and both domestic and foreign capital started to leave the country at a rapid pace. The sudden reversal of capital flows caused a sharp contraction of the economy.3 Unemployment jumped, investment declined, and bankruptcies surged. Interest rates soared and fears of a major banking crisis were very real. Fiscal revenues were also severely affected, leading to large fiscal deficits both at the federal and at the provincial level.
The Government’s Reaction and the Bank’s Assistance
The government reacted immediately and forcefully to protect the economy from this external shock. It took strong measures to right the fiscal balance by cutting expenditures and raising taxes, actions that were supported by the Argentine Congress, which lent strong credibility to the measures. Under the leadership of Economy Minister Domingo Cavallo, the government also put together an international financial package of $11 billion to support the Convertibility Plan (under which the Argentine peso is linked to the U.S. dollar in a one-to-one ratio) and adopted an IMF program. These measures successfully discouraged speculators. These actions in effect broke the back of the looming crisis.
The World Bank immediately assisted the government to put in place two innovative operations to support the privatization or closure of money-losing provincial banks and the acquisition, merger, or restructuring of private commercial banks.
By the end of 1995, it became clear that the Argentine economy was already pulling out of the short-lived recession. Indeed, in 1996 the economy registered a healthy real economic growth rate of about 4.4 percent. But the adjustment process had entailed serious social costs. Unemployment had reached a high of 18.6 percent in May 1995. The World Bank helped in mitigating these negative effects by supporting the continuation and improved management of priority social and income support programs as well as the establishment of a pilot participatory social investment fund.
The reforms supported under these Bank loans were later reinforced and expanded by lending for the reform of provincial finances, maternal and child health and nutrition, and health insurance reform.
Initially there were fears that Brazil might suffer tequila effects similar to Argentina. The Brazilian stock market lost one-third of its dollar value between December 20, 1994 and March 1995, and there was some capital flight. However, it turned out that the introduction of the Real Plan in mid-1994 provided the necessary strength to keep the economy on its path of growth with equity. The Plan had introduced an exchange rate anchor with flexibility to move within a band, deindexed the economy, and introduced tight credit and monetary policies. Growth maintained an average of about 4 percent per annum during 1993–96, runaway inflation was brought under control, the balance of payments turned in a strong performance, and indices of poverty declined. Because of labor market flexibility, stabilization was achieved without a large increase in unemployment. This economic performance has been rewarded by the international financial markets: large private capital inflows continue to finance the deficit on the current account on increasingly favorable terms. In the longer term, though, the current and fiscal deficits will have to be controlled through a variety of measures, including increasing the national savings rate, structural changes in the public sector, and stimulating a more competitive and outward-oriented private sector. The Bank is assisting Brazil with finance for such initiatives, as well as for social development and protection of the environment.
The East Asia Crisis
The crisis was precipitated by a speculative attack on the Thai baht in mid-1997. Efforts to support the currency through intervention, interest rate increases, and restrictions on foreign speculators ultimately failed. Domestic companies added to pressures on the exchange rate as they rushed to repay foreign debt and hedge their foreign exchange exposure. After announcing reserves losses of $8.7 billion in defending the currency, the central bank of Thailand let the exchange rate float on July 2. By the end of the year the baht had depreciated by 93 percent (compared with June 1997), and the stock market had fallen to 37 percent of its June level in dollar terms. The devaluation of the baht triggered a collapse of market confidence in Indonesia, Malaysia, and the Philippines, and their exchange rates plummeted in July/August 1997.
The East Asia crisis is different from previous financial crises in developing countries because the source of difficulties can be found in private sector decisions. Public sector borrowing played a small role and inflation was low compared to most developing countries. Furthermore, the East Asia countries had been running fiscal surpluses or small deficits, and the size of public debt was not a relevant factor. It was the short-term maturity structure of private debt that was the major source of financial vulnerability.
At the time of the crisis the international environment was characterized by high rates of growth in world trade, low international interest rates, and a favorable environment for additional borrowing and equity flows. However, some external factors did play a role. The appreciation of the U.S. dollar in the last two years contributed to the exchange rate appreciation of Southeast Asian currencies with the consequent fall in export growth rates. The decline in the market for computer chips in 1996 contributed to the weakness of the Korean economy.
While factors that made the East Asia economies vulnerable are rooted in private sector financial decisions, governmental policies regarding exchange rates, insufficient financial regulation, and government guarantees (implicit or explicit) played an important role in creating the incentives that led to the particular size and character of external financing and internal misallocation.
The Bank’s response has focused on issues of corporate governance and insolvency, and bank restructuring.
The issue of corporate governance has been frequently highlighted as a major element of the East Asia crisis. There is a simple reason for this renewed interest in the system by which companies are directed and controlled. It is the clear evidence that a combination of directed lending from banking systems and overreliance on debt-based investment in often economically unsound projects by the private corporate sector has been responsible for an unsustainable expansion of foreign currency-de nominated debt and a resultant sharp increase in debt-servicing costs as exchange rates have fallen. In Korea, for example, corporate debt is estimated to be in the range of $300 billion. For the five largest conglomerates in Korea, the increase in their average total exposure to banks from 1996 to 1997 was 47 percent and their debt/equity ratios as of December 1997 ranged from 3.4 times to 9 times.
The objective of a good corporate governance system is to ensure sound decision making that reflects the interests of the shareholders of the company. While corporate governance depends ultimately upon the skills and business judgments of individual company directors, the framework for corporate governance should prescribe clearly the nature of the directors’ role and the duties owed by each director to the shareholders, and should provide clear incentives and mechanisms for directors to perform their functions. The essential elements of that role are setting the strategic direction for the company, ensuring its implementation through competent management accountable to the board, monitoring the actions of management, and providing information regarding the affairs of the company to shareholders, creditors, and, in the case of listed companies, to the public.
In our work on these issues in East Asia, we have encouraged governments to rethink the importance of a good corporate governance framework as a key element of improving corporate performance. The starting point is to ensure that the responsibilities of directors for setting policy and avoiding self-interest are spelled out in the law. Directors should be required to exercise their powers only in the interests of the company, to disclose to their fellow directors, and to refrain from voting on any transaction in which they have a personal interest, and to ensure that the business of the company is not carried on in such a way as to create a substantial risk of serious loss to creditors.
The next element of the framework is to strengthen the information flow to the board of directors to ensure they are receiving reliable financial information and to provide that information to shareholders and others to allow them to monitor the directors’ actions and to hold them accountable for their performance. The accounting and auditing standards applied in the East Asia crisis countries have been shown to be inadequate to disclose fully to regulators, banks, shareholders, and the market the financial standing of the corporate sector. The Bank has therefore encouraged countries to strengthen their laws and regulations to require companies to prepare and disclose financial information that is consistent with best international accounting practices and that is audited in accordance with best international auditing standards. Both Korea and Thailand, for example, have decided to move rapidly to adoption of international accounting and auditing standards.
The third element of the framework is both internal and external monitoring of the actions of boards of directors. For countries influenced by the civil law tradition, it is common to have a two-tier board structure whereby a supervisory board representing shareholders will monitor an executive or management board. Countries influenced by the common law, on the other hand, have a unitary board system with a single board comprising both executive and nonexecutive members. Whichever system is used, the Bank has drawn attention to the importance of the role of independent nonexecutive directors who can make an independent contribution to corporate decision making, and to the performance of the internal and external audit function.
The external monitoring function of corporate decision making derives in part from well-qualified and independent auditors, reporting to regulators and shareholders to assure them of the integrity of the company’s financial disclosures. And finally it derives from the scrutiny of minority shareholders with clear legal rights and protections who can demand information from the company and can, when necessary, enforce the duties of care and loyalty owed by company directors.
The role of bankruptcy in East Asian economies has traditionally been muted by cultural, social, and political factors. For the socialist economies of Vietnam, Mongolia, and China, corporate bankruptcy was largely irrelevant since most enterprises were and still are state-owned and almost all credit was provided by state banks. So bankruptcy, as a mechanism for adjusting the interests of owners and creditors, was of marginal importance since the interests were ultimately identical.
For the mixed economies of Indonesia, Thailand, and Korea, social factors have tended to predominate in the contest between debtors and creditors, particularly where the debtor has been a major employer. Though these latter countries have insolvency laws in force, formal insolvency proceedings have been uncommon, at least until the latter part of 1997. Where proceedings have been taken, the court process has been slow and unpredictable. Specialized bankruptcy or commercial courts where judges are trained in business laws and economics and where urgent matters, such as the initiation of bankruptcy or reorganization, can be dealt with as a priority are generally not found in the region. Government agencies such as the Indonesian Orphans Chamber also commonly play a significant role in the administration of insolvent companies to the exclusion of creditor-appointed or nominated representatives.
Faced with large-scale financial distress in the corporate sector, the East Asia crisis countries need urgently to carry out a significant repositioning of the role of bankruptcy laws and their supporting institutions. Banks are carrying exceptionally high levels of nonperforming corporate loans. In the past, relaxed reporting standards would have allowed banks to delay full provisioning of these loans, but countries are moving to adopt internationally recognized accounting principles and reporting standards and are strengthening the role of regulatory oversight. At the same time, banks in Indonesia, Thailand, and Korea face the twin pressures of declining profitability and the restoration of internationally accepted capital adequacy levels. As a result, a great deal of nonperforming corporate debt will be transferred to restructuring agencies, whose objective will be to maximize recoveries through increased pressure on corporate debtors.
Trade creditors of corporates are themselves facing severe liquidity pressure as a result in part of the buildup of arrears on normal trade transactions. In the absence of speedy and predictable debt-recovery procedures, trade suppliers will either themselves fall into insolvency or contribute to the spiral of nonpayment by failing to pay their own creditors and ultimately their employees.
Speedy liquidation of insolvent corporates is however only a partial solution and carries its own risks. In circumstances of widespread economic dislocation, such as those facing countries in the region, institutions such as the courts would likely be overwhelmed by a sudden shift toward liquidation of companies facing cash flow insolvency.
Improvements in liquidation mechanisms should therefore be accompanied by flexible reorganization procedures for corporates capable of achieving positive cash flows as a consequence of liability restructuring. The design of rules for financial restructuring that strikes an acceptable balance between the interests of different classes of creditors (secured and unsecured) and between the interests of creditors and owners should be an immediate priority.
Although the Bank has supported many developing countries in the reform of their financial sector institutions, the importance of strong and transparent systems of financial sector regulation and supervision has never been so clear as it has been in the East Asia debt crisis. Despite the unprecedented achievement of the East Asia miracle in lifting millions of people out of poverty, the debt crisis revealed that weaknesses in the core financial structures can undermine even the most apparently successful economy. Consequently, one of the Bank’s primary concerns in providing assistance to the East Asia debtor countries and their neighbors has been establishing the best measures for restructuring government banking supervisory systems to recognize and correct financial sector problems before they reach crisis proportions and for rebuilding financial sector institutions to provide a firm base for future growth.
The Bank’s program of assistance to those countries most affected by the East Asia debt crisis—Thailand, Indonesia, and Korea—has focused on a series of key initiatives that Bank experience in previous debt crises has proven to be critical to successful bank restructuring. These key initiatives include emergency measures to restore confidence in the banking system through government guarantees of bank deposits (in the case of Indonesia and Korea these guarantees were also extended to bank creditors), legislative and regulatory measures to strengthen banking supervision and enforcement, legal measures to enhance the capability of the depository insurance system to handle insolvent institutions, and the establishment of government entities responsible for receiving, managing, and selling the nonperforming loans of failed institutions or institutions that have been recapitalized by the government.
One of the most important elements of successful bank restructuring is the strengthening of prudential regulations—in particular the timely recognition of nonperforming loans and adequate provisioning against loan losses. The Bank has encouraged the governments of Thailand, Indonesia, and Korea to adopt the standards for recognizing loan losses, asset classification and provisioning against losses, which have been set out by the Basle Committee on Banking Supervision. In addition to the adoption of Basle Committee standards, the Bank has emphasized the value of having written regulations that (i) adopt internationally recognized accounting and auditing standards, (ii) govern banking activities such as prior notice to the regulatory authorities of significant transfer of shares, major acquisitions and investments, and approval of off-shore operations, (iii) ensure periodic on-site examinations as well as off-site monitoring, and (iv) provide a system of escalating compliance measures that permit bank supervisors to take prompt corrective actions before the only alternative is closure of the bank.
Another important element of bank restructuring is the government’s ability to close or recapitalize banks that fail to meet established levels of capitalization and solvency. The Bank has encouraged Thailand, Indonesia, and Korea to adopt regulations that explicitly set out the procedures for government intervention of failed institutions. Among the legal issues to be considered in such government interventions are the rights of existing shareholders and bank creditors, including bond holders. These issues were encountered and thus far successfully resolved by the Korean government in its recapitalization of two major commercial banks, Korea 1st and Seoul, by having the existing shareholders consent to a substantial share reduction (93 percent) in exchange for the government’s injection of new capital.
The final element of bank restructuring is the mechanism or mechanisms the government establishes to collect, manage, and sell the non-performing assets of failed or recapitalized banks. Although it is possible to set up asset recovery mechanisms within a recapitalized bank (as was successfully done in the Norwegian and Swedish debt crises several years ago), the governments of Thailand, Indonesia, and Korea have chosen to adapt variations of the U.S. model (developed during the S&L crisis), which established a central asset resolution corporation responsible for the disposition of nonperforming loans from several failed banks or other insolvent financial institutions. In each of these countries, the Bank has helped the government to establish trusts or corporate entities with transparent procedures for the fair and orderly disposition of assets. Of course, the ability to maximize recovery on nonperforming assets will depend to a great extent on the adequacy of bankruptcy laws and procedures.
The Bank has used structural and investment lending to respond to both regional crises coupled in some instances with technical assistance loans. Furthermore, in the case of Korea, the Bank introduced a new type of loan permitted by a 1946 interpretation of the Articles of Agreement, but not used until now.
The Bank is required by its Articles to make loans or guarantee them only if they are for the purpose of specific projects of reconstruction or development (Art. III, Section 4(vii)), except in special circumstances. In 1946, the Board of Governors requested the Bank’s Executive Directors to issue an interpretation of the “special circumstances” provision so as to allow the Bank to make “loans for programs of economic reconstruction and the reconstruction of monetary systems, including long term stabilization loans.” The interpretation report concluded that “[i]n determining whether or not to make or guarantee any such loan, it is, of course, for the Bank to decide whether or not such loan conforms to the conditions specified in the above-quoted provisions of Article III of the Articles of Agreement of the Bank, and, in the case of a loan which is not for the purpose of a specific project of reconstruction or development, it is for the Bank to decide whether special circumstances exist which justify it in making or guaranteeing such loan.”
Based on the above, the Bank has been considered to have the legal power to make loans and guarantees to finance a program of economic reconstruction of the monetary system of a country including a long-term stabilization loan. For this purpose, the Bank made a $3 billion loan to Korea.
Renewed lending to Korea was also considered in the context of the Bank’s graduation policy, since Korea had graduated from Bank lending in 1994. Under the Bank’s Articles, the Bank must be “satisfied that in the prevailing market conditions the Borrower would be unable otherwise to obtain the loan under conditions which, in the opinion of the Bank, are reasonable for the Borrower.” It has been the practice for countries to stop borrowing from the Bank after they reached a certain level of economic development as reflected in a GNP per capita of $1,000 in 1970 dollars. The practice was codified in a graduation policy approved by the Board in 1982. In accordance with this policy, when a country reaches a certain GNP, the Bank reviews the overall economic situation of the country concerned, bearing in mind access to external capital markets on reasonable terms and the extent of progress in establishing key institutions for economic and social development. This policy was further clarified in 1984 to indicate that the review did not necessarily mean an automatic cut-off but may lead to consultations with the country concerned on future Bank involvement. It was made clear at the time that resumption of lending could occur if circumstances changed. Thus, Gabon, which had already graduated, became eligible again when its oil revenues dropped. Venezuela ceased borrowing from the Bank in the 1970s and became a borrower in subsequent years. Under this policy, lending to Korea resumed.
Crises are opportunities for change and for introducing the reforms needed to avoid them in the future. The Bank has responded with assistance focused on the social effects of the crises and on their impact on the financial systems of the affected countries. In each of the East Asia debt crisis countries, the Bank has stressed the need for taking reform measures that avoid undermining achievements in poverty reduction and that do not create problems of long-term moral hazards. The Bank has also encouraged reforms that establish transparent and objective government regulations and promote private sector responsibility for good corporate governance based on best international practices. As we have seen, many of the measures relate to legal institutional changes, which will need to be sustained over time to take hold and function effectively. The actions taken in the context of conditionality would thus need to be complemented with instruments that address long-term needs rather than those of the immediate crises.
4B. Recent Financial Crises and the Inter-American Development Bank
Although this paper deals in general with financial crises from the standpoint of a regional development bank, my comments will be limited to the 1995 peso crisis in Latin America. In that crisis, the Inter-American Development Bank (IDB) played a role similar to the role of the Asian Development Bank in the recent problems in Asia.
Since there are only a few people in the audience from Latin America who know exactly what the IDB is, I thought it might be worth taking just a minute to explain just what we are. The simple thing to do is to think of the IDB as a small World Bank that makes loans only in Latin America and the Caribbean. Our Charter, or Articles of Agreement, was patterned after, and is extremely similar to, the Articles of Agreement of the World Bank. Like the World Bank, our members are governments; and 45 member governments around the world are our shareholders. Most members are in Latin America and the Caribbean, but Japan, the major European countries, Canada, and the United States are also participants. Our operations and loans are similar to those of the World Bank. Our lending volume is around $7 billion a year, which is relatively small compared with the IMF and the World Bank, and certainly small compared with the resources needed for major financial crises.
How do we respond to crises? What tools do we have and what kind of loans can we make? Andres Rigo touched on this question when he described the World Bank investment loans and adjustment loans. Like the World Bank, our lending principles are set forth in our Charter and, similar to the World Bank, our loans must principally finance specific projects. When our organizations were set up, they were intended to finance projects like roads, power stations, and ports that had bricks and mortar and equipment. The second general principle of our lending has been that our funds should only be used to meet the foreign exchange costs of projects. Only in special cases should our money, which is provided primarily in hard currency, be used to finance local expenditures. Given these requirements, the traditional form of our lending has been to provide the foreign exchange component of investment projects. Obviously, there was a heavy emphasis on infrastructure, and disbursement was against actual expenditures on the project. For example, as a road was being constructed, the IDB paid against progress on the construction.
In spite of these Charter requirements, the modalities of our lending have evolved to meet the changing circumstances of our borrowers. The most important evolution took place in the late 1980s when we moved beyond lending for specific projects to what Mr. Rigo described as sectoral or structural adjustment lending.1 These are what you all know as “fast-disbursing” loans. The disbursements on these loans are very lumpy and are generally made in 2 or 3 large tranches as the countries satisfy policy objectives set forth in the agreement between the IDB and the borrower. In other words, if we made a $150 million loan, we would typically disburse in 3 tranches—the initial tranche might be 50, the second tranche 50, and the third tranche 50 over a relatively short time, typically a year and a half to two years. In the early 1990s, we were restricted by our shareholders to providing only 25 percent of our resources in this fast-disbursing category, and in the years since 1994 further restricted to 15 percent. Thus, a relatively small percentage of our traditional lending has been in the form of fast-disbursing loans that are important for a quick response to a crisis.
Given this background, how did we react to the Mexican peso crisis in 1995? Obviously, the problem was far too large for us to think of dealing with it by ourselves. The only role we could play was part of the international effort mounted by the IMF and the U.S. government. We owed this responsibility to our borrowing countries—Mexico and the other countries in Latin America facing the possibility of the domino effect. We felt it absolutely critical to do what we could. The only questions were what form the support could take and how quickly we could move. We sent a mission to Mexico in early January 1995 to explore the type of fast-disbursing projects that could be undertaken quickly and that would, at the same time, establish reform mechanisms to contribute to longer-term growth.
As we looked at possibilities along with the World Bank, we faced a number of constraints created by our role as a long-term development institution and not an institution geared to respond rapidly to liquidity crises. Like the World Bank, but unlike the IMF, we are a bank dependent on the capital markets for the bulk of our funding. As an institution that goes to the capital markets, it is important for us to maintain a balanced portfolio of loans. We are concerned that if we made a huge commitment to Mexico and to one or two other countries in Latin America, we might be lending too much to a single country or group of countries. We had a problem of portfolio concentration, where it looked as though as much as 35 or 40 percent of our total loans in a given year might go to Mexico and perhaps Argentina. The amount of loans that we had outstanding to those countries would increase dramatically: this was obviously a constraint in considering our response to Mexico.
The other major problem was the 15 percent limit on fast-disbursing loans. Clearly, it wouldn’t help to provide longer-term investment loans that would disburse over a period of years. A third problem was our longstanding policy of not refinancing loans or participating in debt restructuring. This policy dated from 1962—the theory being that we were supposed to invest in productive projects and that refinancing loans and debt restructuring did not meet that test. Obviously, where there is too much debt, an institution unable to refinance debt is not very helpful. It is apparent that we were faced with a number of major policy constraints as we looked at what we might do. Nevertheless, we went ahead with large loans in both countries. Given the magnitude of the problem, the potential systemic threat to Latin America, and the fact that we were part of an IMF-led effort allowed us to conclude that we should stretch our policy to the limit and make exceptions so that we could participate in a useful way. So what did we then do?
In Mexico, we made two loans that were geared specifically to the crisis. One was a $750 million loan to help restructure the financial system. This was the largest loan in the history of the IDB, but it was obviously very small compared with the IMF’s $18 billion and the U.S. loan of $20 billion. It was also very small compared to what the Asian Development Bank contributed in the recent crisis in Asia. The loan was cofinanced with the World Bank: adding our resources to theirs, we together provided $1.5 billion to Mexico. The purpose was to help restore confidence in the Mexican financial system. A special portion of this loan was intended to restructure and refinance loans made to private sector borrowers. Mr. Rigo touched a little on the problems that had been created in Asia because of the inability of the private sector borrowers to repay. Our funds, along with the World Bank funds, helped to provide liquidity to deal with the very real problem of the Mexican banks’ exposure to domestic corporate debt. As I have mentioned, this required us to make a major exception to our long-standing policy. Because we were part of an international effort and because of the threat to the entire Mexican economy, we felt the exception was justified. Since that time we have refused to participate in other projects that would involve substantial debt financing or restructuring when there was no systemic threat or no threat to the country’s economy as a whole.
The IDB also made a second loan of $500 million to protect essential social services to the poorest in Mexico. Again, this was co-financed with the World Bank, and was a useful complement to the IMF program. The loan financed short-term public works in order to create jobs. We also supported education, nutrition, and health programs for those hardest hit by the crisis.
In Argentina, we responded quite similarly, making a $750 million loan for the privatization of provincial banks, cofinanced with the Export-Import Bank of Japan and the World Bank. The provinces had borrowed heavily from provincial banks to fund their own deficits, leaving the banking system in most of the provinces in Argentina in considerable stress. The purpose of the $750 million loan was to create the conditions that might lead to the privatization of these state-owned or provincially owned banks. The loan provided liquidity to help repay private sector depositors of the banks, to pay other creditors, including the central bank, and to hire consultants to aid with the privatization of the banks. As in the case of Mexico, we also provided $450 million for a program of social sector reform, covering unemployment, nutrition, and education. A unique aspect of this loan was the provision of subsidies to families as an incentive for them to keep their children in school. (In a financial crisis, families tend to take their children out of school to help augment family income.)
I want to cover briefly the major legal issues raised by these transactions. I think that they are implicit in what Mr. Rigo and I have said. Clearly, one of the major legal issues was the need to justify exceptions to the policy on refinancing debt and the 15 percent limit on sector loans. We interpreted our charter in a liberal fashion to permit this. One of the advantages of the charters of institutions like the World Bank and the IDB is that they provide opportunities for fairly liberal interpretation. Our charter says that our loans must be principally for investment projects. The word “principally” gives one a lot of latitude to permit other types of activities, and clearly we used that latitude to endorse the kind of loans that we were making.
We also reviewed our existing loan contracts outstanding with Mexico to see if we could legally increase disbursements or make advances under these contracts to provide further liquidity. We did provide some funding by being more flexible in how we interpreted our ability to disburse or advance funds through existing loans. Finally, we worked out an arrangement with the Bank for International Settlements (BIS), which had organized the bridge loan from many European countries to Brazil. The arrangement provided for making disbursements directly to the BIS to repay the bridge loans made to Mexico.
What did we learn from all of this? The major messages for the regional banks are that we have to be flexible in interpreting our charter and our policies and that we have to be able to move quickly. Otherwise, we become irrelevant. However, flexibility may not be enough to fit emergency loans into our traditional lending modalities. We currently have no instrument or product tailor-made for these kinds of crises. We hope we won’t need this kind of mechanism.
The Asian crisis did, however, prompt some in the Bank to raise the issue of whether institutions such as the IDB should establish some sort of contingency or stand-by facilities that would enable us to respond faster in the event of another crisis without the need to make policy exceptions. Policy issues will have been dealt with beforehand so that as soon as a crisis arises, we will be able to move quickly. Obviously, this kind of facility would have to be large enough to be meaningful and be quick disbursing. We would probably want a short repayment period as opposed to our traditional 15-year loan, and we would probably want market interest rates as opposed to our current rates that reflect some subsidy element. The advantages and disadvantages are fairly obvious. There are some who say that this kind of a facility would have a great preventive effect, and it would give comfort to lenders and governments in knowing that funds would be immediately available. With that assurance, there wouldn’t be immediate withdrawal of funds, which is what happened in Mexico with short-term government securities. On the other hand, those who have doubts about this facility raise the moral hazard issue. If you create this facility are you encouraging more lax lending procedures by financial markets and more lax borrowing by governments. We are not close to establishing such a facility. But it does suggest that we ought to consider having in place a mechanism to enable us to respond quickly to these kinds of crises.
HERBERT V. MORAIS
Recent financial crises in Asia and Latin America and the current consideration to grant the International Monetary Fund jurisdiction over capital movements dramatically highlight how far the international financial institutions have gone in interpreting the dreams of their founding fathers to address unprecedented financial crises. I am not suggesting that the founding fathers would turn in their graves when they see what their offspring have done in recent years. Rather, my point is that these institutions have displayed considerable imagination, resourcefulness, and flexibility—within the framework of their charters and lending policies—in addressing the crises in Asia and Latin America. Against the backdrop of the earlier presentations, I would like to highlight some of the common and different approaches taken by the international financial institutions and also point to some shared lessons and concerns that have arisen from this experience.
First, while all international financial institutions share a common general objective to promote the economic and financial well-being of their member countries, they have different mandates, which influence their respective strategies for addressing financial crises.
By definition and mandate, the IMF, like the proverbial fireman, is first in line to respond to balance of payments crises. That is the central function of the IMF. Its response to a member’s balance of payments crisis has to be swift and effective if investor confidence in the economy is to be quickly restored. When confronted by such a crisis, a member is entitled, under a number of different facilities (usually a stand-by arrangement), to draw on the resources of the IMF when this is necessary to solve a short-term balance of payments need. The swift assistance provided by the IMF to Indonesia, Korea, and Thailand in recent months is the best example of this process. Mexico is an earlier example. The IMF’s assistance is provided on the basis of commitments from the recipient member countries concerned to implement sound macroeconomic adjustment measures and to fulfill other performance criteria including critically needed economic and legal reforms.
In contrast, the multilateral development banks have not always been able to join the IMF in the initial stages of a balance of payments crisis. This is partly a result of their different mandates and schedules for processing and approving financial assistance. However, they have come through with substantial assistance subsequently through their normal lending operations involving both investment and adjustment loans. Mexico in 1994–95 is a good example. Because of the sheer magnitude of the recent Asian financial crisis, the World Bank and the Asian Development Bank were called upon on an exceptional basis to provide significant amounts of financial assistance on a fast track to supplement the financing provided by the IMF, and they responded quickly and effectively.
Second, the international financial institutions have for the most part also employed different instruments to provide their respective financial assistance. While the IMF has generally focused on quick, shorter-term assistance to help a member country tide over a balance of payments crisis, the multilateral development banks have generally concentrated on longer-term investment lending and some adjustment and program loans. All the institutions have also provided some form of technical assistance, particularly for legal reform, where appropriate.
Third, the recent financial crises have tested to the limits the provisions of the charters and the lending policies of the international financial institutions.
In the IMF, for example, we have witnessed a significant increase in the limits of IMF exposure in terms of a member’s quotas. Although the IMF’s access policy permits exceptions to the general access limits, these exceptions have now become notable for their size and frequency. However, through a combination of a member’s undertaking to implement tough reform measures under a comprehensive macroeconomic program and the IMF’s own strong conditionality, the IMF has been careful to ensure that this increased exposure is supported by adequate safeguards for the use of its resources. The IMF has also strengthened its capability to respond quickly and effectively to major financial crises through the establishment of an emergency financing mechanism and a supplemental reserve facility.
The World Bank’s Articles of Agreement stipulate that its loans and guarantees are generally to be made for specific projects, but it has used the “special circumstances” exception to that requirement to justify loans for other special purposes consistent with the Articles. For example, the Bank was able to make its recent loan to Korea using a new type of long-term stabilization loan, which is permitted by a 1946 interpretation of its Articles of Agreement not used until now. Similarly, the Bank was also able to justify loans under the “special circumstances” exception to support Brady-style commercial debt and debt-service reduction operations and to support innovative loans to the banking sector.
In the Inter-American Development Bank, creative ways were found to justify the financing of a larger proportion of local costs in projects, to support debt refinancing in the banking system, and also to provide domestic budget assistance.
In all these cases, both at the IMF and at the multilateral development banks, the responses to these unique financial crises have been imaginative and resourceful.
Fourth, the recent financial crises have brought to the fore the importance and urgency of addressing issues of legal and judicial reform in the crisis countries. In this regard, all the international financial institutions, prior to the onset of the Asian financial crisis, had adopted new policy guidelines and other measures to promote better economic governance in their member countries, including strategies to combat corruption and promote greater transparency in government agencies, financial institutions, and corporate enterprises.
Until very recently, or at least until these new policies were adopted, the international financial institutions were unable to devote much attention to fixing serious deficiencies in the legal framework underpinning the financial and corporate systems of their member countries. There are several reasons for this, including the higher priority normally given to economic measures and the sensitivity and difficulty of seeking changes in a country’s legal system. In accordance with some countries’ requests, the international financial institutions have provided both financial and technical assistance to support legal reforms, but they have not paid adequate attention to member countries’ failures to implement and enforce critical laws, such as those providing for effective prudential supervision of banking and other financial institutions and those dealing with insolvency, nor have they focused adequately on issues of corporate governance.
The recent crises in Indonesia, Korea, and Thailand have signaled the importance of paying closer attention to legal reform and corporate governance in our member countries. It is significant to note, in this context, that the IMF and the World Bank are supporting major legal reform projects in Indonesia, Korea, and Thailand, particularly in the areas of insolvency law, banking laws, and corporate governance. In Indonesia, the IMF is also involved in a judicial reform project that led to the establishment of a separate commercial court and the training of judges for that new court. It is clear that the Asian financial crisis has provided a strong endorsement of the good governance policies recently adopted by the international financial institutions and has also emphasized the importance of these institutions taking a more active role in promoting legal and judicial reform.
Fifth, the recent Asian financial crisis has certainly brought to the fore again the issue of openness and transparency covering:
openness and transparency by governments of member countries,
openness and transparency by private sector entities, and
openness and transparency by the international financial institutions, particularly the IMF, which receives a significant amount of confidential and market-sensitive economic and financial information from its member countries.
The IMF is actively encouraging member countries to be transparent about their economic performance by improving the dissemination of economic and financial data to the public. There are at least two advantages to doing this.
When economic policies are transparent, policymakers have more incentive to pursue sound policies. As the IMF’s Managing Director has posed the question in some of his recent speeches, would the Central Bank of Thailand have accumulated such large forward liabilities if the public had regular access to information on central bank operations? On the contrary, as the Managing Director pointed out, the authorities would have had to face the problem of Thailand’s dwindling reserves much sooner and, most likely, have taken corrective action before reserve losses became so large and precipitated the crisis.
Similarly, when timely, accurate, and comprehensive data are readily available, markets are likely to adjust more smoothly. Greater transparency in providing economic and financial information will strengthen market discipline and enable markets to operate in an orderly way, thereby avoiding the kind of market surprises or disruptive market reactions that characterized the recent Asian financial crises.
Insofar as calls for greater openness and transparency by the IMF with respect to economic and financial data provided by member countries are concerned, the problem is somewhat more delicate and difficult.
Members provide a great deal of economic and financial information to the IMF (and indeed also to the multilateral development banks), under explicit or implicit confidentiality undertakings, for the sole purpose of enabling the IMF to carry out its activities (such as surveillance) and operations. A good part of this information is of a highly sensitive nature that has to be handled with great care. That information is the property of the country. Thus, the IMF cannot on its own decide to release such market-sensitive information without the consent of the member country. Subject to this caveat, the IMF has taken several steps to publish a variety of reports such as Recent Economic Developments and Public Information Notices, which reflect the summings-up of Board discussions on the Article IV consultations with member countries.
The IMF has a special cooperative and consultative relationship with its member countries, serving as a private, discreet, and confidential advisor to them, providing policy advice on economic and financial matters and, where appropriate, stepping in to prevent a financial crisis. This special relationship would be seriously jeopardized if the IMF started to publicize its concerns to the public. If it did this, there is also the added risk that the IMF might precipitate the very crisis that it is helping the member country to prevent.
What challenges do the recent financial crises present for the IMF, the World Bank, and the regional development banks? In spite of our different mandates and approaches, the crises have brought out a considerable convergence of interests and strategies among us. This suggests possibilities for closer and more effective collaboration in the future—possibly even setting up special facilities on an intra-institutional basis.
A central problem contributing to the recent financial crises has been the lack of reliable information. How do we balance the various considerations mentioned, namely, the IMF’s need to maintain its confidential relationship with members against the need to provide good, adequate information to the market? We will need to find ways to strike an appropriate balance on this issue.
How far is it appropriate for the international financial institutions to go in intervening in matters of legal and judicial reform? And how should we go about doing it? Knowing that legal and judicial reform touches on political sensitivities, how can we do this without appearing to intrude on the sovereignty of the country?
I wish to acknowledge the assistance received from my colleagues Ms. M. Waxman and Messrs. R. van Puymbroeck and D. Webb in the preparation of this presentation.
Brazil had total net inflows of $29 billion and Argentina $22.4 billion. See Shahid Javed Burki and Sebastian Edwards, Dismantling the Populist State; The Unfinished Revolution in Latin America and the Caribbean (The World Bank Group, 1996) at 6.
4.6 percent in 1995.
See herein Andrés Rigo, The World Bank’s Response to the Latin America and East Asia Crises, Chapter 4A.