Preventing a Recurrence of the Asian Crisis

Barry Eichengreen

University of California, Berkeley

March 2000

It is now more than two years since then U.S. Treasury Secretary Robert Rubin gave his famous speech calling for a ‘new international financial architecture.’ Since then, many of us have used the conference circuit to describe our visions of what such an architecture would entail. Since neither the problems nor our proposal have changed, we are constantly danger of running out of new ways of making our familiar points.

Fortunately, a major report on how to reform the international financial institutions and strengthen the international financial architecture has been issued in the United States by the International Financial Institution Advisory Commission. This report has received very considerable publicity in this, a presidential election year. For freshness of presentation, it comes in the nick of time. I hope our chairman, who was a member of that commission, will forgive my use of this pedagogic device.

The Meltzer Report identifies weak banking systems and soft currency pegs as the principal threats to stability in our financially globalized world, and argues for strengthening prudential supervision and abandoning intermediate exchange rate arrangements in order to make that world a safer financial place. These are unquestionably the right lessons to draw from the recent wave of crises, and from the Asian crisis in particular. But while the report provides a detailed list of steps needed to strengthen banking systems, it offers only a cursory discussion of the exchange rate problem.

In particular, while assuming that most countries, in the short run at least, will prefer to float, the report offers few recommendations about how to formulate policy in the absence of an exchange rate anchor. ‘Sound and stable budget and credit policies’ that avoid both excessive inflation and excessive deflation are desirable, it writes, but beyond that it offers few specifics.

This is exactly the problem. It has been precisely the failure of domestic monetary authorities to adopt a clear, coherent framework for the formulation of monetary policy, in place of the previous exchange rate anchor, that has undermined the credibility of post-peg policies, weakened investor confidence, encouraged capital flight, and accentuated the recessionary effects of abandoning currency pegs. I think the IMF could have done more to help emerging markets develop such a strategy. For a long time it resisted endorsing the obvious alternative, inflation targeting. In fairness, the Fund’s attitude is now changing, as is evident in its endorsement of inflation targeting in the Brazilian program, and in its March 2000 conference concerned with inflation-targeting experience in emerging markets. But unless the IMF consistently advocates an explicit, operational alternative, it is unlikely to be effective in lobbying countries to move away from unstable intermediate exchange-rate arrangements.

The report criticizes IMF rescue packages. The Mexican and Asian rescues, it argues, encouraged international investors to pour money into Russia and more generally undermined market discipline. The conditions attached to the IMF’s programs were inappropriate, it argues. There is little evidence from cross-country studies, it argues further, that conditionality leads to an improvement in economic performance. Where conditionality runs roughshod over domestic sovereignty, it makes it harder for the citizens of the crisis country to achieve the social consensus needed to undertake necessary reforms.

We have heard these criticisms before. What we have not heard is the conclusion that IMF lending practices should be reformed not just to limit moral hazard but also to eliminate invasive, counterproductive IMF conditionality. To this end, the commission proposes that the Fund prequalify eligible countries and then lend to them unconditionally.

The problem is that lending unconditionally would mean lending to those who would make least sensible use of the proceeds. The commissioners propose to solve this problem by adapting a formula, Bagehot’s rule, from the literature on central banking. Bagehot’s idea was that central banks, in order to stabilize domestic financial markets and institutions, should lend only at penalty rates and against good collateral. If the authorities lend exclusively at high interest rates and against good collateral, only solvent banks whose problems are of a short-term, liquidity-based nature will wish to borrow. Banks with more serious balance-sheet problems would only weaken their financial condition by incurring additional liabilities that they have to repay at a penalty rate, something that their existing creditors would oppose. Because the obligation to the central bank is fully collateralized, it is effectively senior to these other obligations; it subordinates other debt. Thus, the high-interest-rate rule and the seniority of IMF loans suffice to distinguish cases of insolvency (where suspending payments and restructuring existing obligations is the only way of putting the distressed entity back on its feet) from cases of pure illiquidity (where a short-term loan from the IMF will resolve the problem). Indeed, the Fund is relieved of the responsibility of having to distinguish the two cases. The indebted government will decide for it, so long as the Fund charges a penalty rate and ensures that its loans enjoy seniority.

There are a number of difficulties in transferring a formula which has performed admirably in the domestic central banking context to the international domain. The reality is that national policy makers are uncertain about the extent to which their country’s problems reflect a sudden disruption to liquidity or poor long-term fundamentals. More than two years after the outbreak of South Korea’s crisis, two rival interpretations of its plight in 1997-8 continue to compete: one which attributes it exclusively to investor panic, and another which cites ‘soft rot’ in the banking and industrial sectors. If the experts can’t agree after two years, how can we be confident that a modest penalty will deter uncertain policy makers faced with an immediate crisis?

Even if a government is certain that the country is experiencing a problem with fundamentals, will an interest rate even several hundred basis points above normal commercial borrowing rates and seniority for Fund claims prevent it from approaching the Fund? If the government and other members of society have the same discount rate, then, yes, it will stand to lose by borrowing from the IMF on senior terms at a penalty rate. Borrowing from the Fund subordinates existing debts, exacerbates the deficit (through the high borrowing cost), and makes it harder to repay private debts. But the reality is that governments have finite lives. Politicians therefore care about short-run outcomes C they have high discount rates. It is not clear, in other words, that a high interest rate will deter them. Nor will they be deterred by the prospect of subordinating existing debts if there is only a finite probability that they will still be in office when the bill comes due. Like inadequately capitalized banks that gamble for resurrection, government officials will find it irresistible to borrow from the Fund in order to scrape by for a few more weeks in the hope that good news turns up in the meantime. The idea that the Fund can filter out these cases by charging a penalty rate and ensuring that its claims enjoy seniority ignores these political realities.

The unavoidable implication is that it will still be necessary to attach other conditions to IMF lending. The commission proposes moving away from ex post conditionality C that countries which borrow should be required to implement certain policy reforms C to prequalification as a way of limiting the discretion the Fund has to apply those conditions. Only countries which satisfied a list of necessary preconditions, whose intent is to ensure that their fundamentals are in order and any problems they are experiencing are of a short-term, liquidity-related nature, would be permitted, under the proposal, to borrow from the IMF. The core preconditions have to do with the regulation of national banking systems, which should be adequately capitalized, face hard budget constraints, and forced to compete freely with foreign financial institutions. With their own capital at stake, faced with the chill winds of foreign competition, and forced to swing without the safety net offered by explicit or implicit government guarantees, banks will be forced to upgrade their prudential practices. Countries with strong banking systems, the argument goes, are unlikely to experience anything other than liquidity problems arising for reasons beyond their control.

This proposed solution skates over important issues. For one, it ignores the lessons of the attempt with prequalification learned from the IMF’s experience with its recently established Contingent Credit Line. The worst thing that can happen under such a system is for a previously prequalified country to be dequalified; an investor panic and adverse macroeconomic consequences are almost certain to follow. If the IMF cannot bear the prospect of decertifying the previously certified, it will set a high standard for certification. The population of certified countries will then approach the null set.

Another difficulty is that structural problems that can set the stage for a crisis are not limited to the banking system. To be sure, if countries strengthen their banking systems and abandon unstable exchange rate pegs, the frequency and severity of crises will be reduced. But they will not be eliminated. An unsustainable fiscal position can also heighten crisis risk, and the last thing anyone wants is for the Fund to lend to countries unwilling or unable to put their fiscal houses in order. Thus, the report also contains a recommendation that countries must satisfy unspecified fiscal conditions. But imagine how hard it would be to settle on a single set of fiscal conditions that could apply to more than 180 IMF members. Inevitably, the implication of heading down this slippery slope is to reintroduce the discretion into IMF conditionality.

A third objection is that hard-and-fast rules for prequalification would prevent the IMF from responding to exceptional events that threaten the stability of the global financial system or inflict acceptable collateral damage on innocent bystanders. Acknowledging this reality, the report contains an opt out, citing ‘unusual circumstances, where the crisis poses a threat to the globl economy,’ under which the Fund would be able to lend more widely to protect the global financial system and innocent bystanders. This is the inevitable implication of the fact that the world is a fragile financial place, but it renders unavoidable the idea that IMF disbursals will decided, in the end, by the discretion of its Executive Board and management, and not by any set of hard-and-fast rules.

Finally, even where collateral damage and systemic stability are not at issue, the principal shareholders of the Fund, faced with a country with problems with fundamentals that prevent it from servicing its debt, will find it politically unacceptable to simply stand aside and let the consenting adults clean up after the problem, this being the implication of the commission’s prequalification proposals. Under present institutional arrangements, restructuring is painful and difficult to achieve. Countries that suspend debt-servicing payments suffer an extended period of lost capital market access and economic stagnation. Investors suffer through an extended period when no interest is paid and no principal is repatriated. The Fund’s shareholders will come under pressure from investors and from those who want to limit the pain and suffering in the crisis country. The pressure to bail out will remain. The only way to avert it is to create more efficient, preferably market-based mechanisms for encouraging debt restructuring. The Meltzer Commission acknowledges this logic, but when addressing it adopts an uncharacteristic posture of caution. As one member has put it, ‘In the interest of >doing no harm’ the Commission did not make specific recommendations in this area.’

The veiled reference here is to ideas like the introduction of collective action clauses (sharing clauses, majority voting clauses, representation clauses) into loan contracts, mediation services to deal with asymmetric information problems, and standing committees of creditors to facilitate negotiations. The specifics of such proposals may be controversial, but their linkage to the commission’s reform agenda is undeniable. If other changes to institutions and procedures in financial markets are made to facilitate market-based solutions to crises, then it will be possible for the Fund to let the consenting adults resolve the problem. Without such changes, however, recommending that the Fund stand aside is patently unrealistic. The report’s emphasis on the advantages of market discipline and market solutions is admirable, but there is a tendency to assume that the necessary infrastructure exists even where it does not.

A final context where this same tension arises is in the report’s discussion of data dissemination, which everyone agrees is desirable and important. The report recommends that, in order to qualify for access to IMF facilities, countries should be required to publish information on the maturity structure of their outstanding sovereign and guaranteed debt and off-balance-sheet liabilities. This will invigorate market discipline and prevent problems with the public finances from festering. But inadequate or inaccurate data will not invigorate market discipline. The adequacy of the data needs to be evaluated, and the results of that evaluation published. Similarly, companies with traded liabilities must use internationally-respectable auditing and accounting standards, and someone has to evaluate their compliance. Antiquated bankruptcy and insolvency procedures need to be modernized, and someone has to be responsible for evaluating whether this is being done. Another agreed lesson of the Asian crisis is that financial stability will remain elusive in the absence of significant progress on all these fronts. The premise of the report is that if banking systems can be strengthened, then these other problems can be left to sort themselves out. This both assumes a solution to one problem (the banking problem) and minimizes the severity of all other sources of instability.

If you agree with me that making the world a safer financial place requires not just a quasi international lender of last resort for countries that succeed in strengthening their banking systems but also ongoing efforts to upgrade auditing and accounting practices, securities market regulation, bankruptcy and insolvency law, and corporate governance, then the agenda for reform is long and complex. The mechanism for completing it will be the promulgation of international standards in the above-mentioned areas, and peer pressure for countries to comply. The Bank for International Settlements, not the IMF, according to the commission, should take the lead in coordinating this standard-setting process.

I will admit to be troubled by this. Despite its recent expansion into Asia, vesting the BIS with responsibility for setting global standards would delegate this task to a small number of high-income countries, which would hardly enhance the legitimacy of the process. Legitimate global standards can only be set by a global institution; the IMF would seem to be the most eligible available candidate. The Fund has universal membership. It conducts annual Article IV consultations with its members. It already attempts to publish the results of those consultations. It already rates each of its members’ compliance with other membership requirements such as currency convertibility. The argument that the IMF, if it is to become less of a fireman, must become more of a policeman, policing countries practices in these other areas related to financial stability, is too compelling to ignore.

To conclude, the commission has made some positive contributions to the literature on how to strengthen the international financial institutions. It has directed attention toward weak banking systems and soft currency pegs as the principal threats to international financial stability. It has highlighted the need for the IMF to refocus on the crisis problem, while leaving poverty alleviation and development to the other IFIs. But its specific recommendations for reforming the operating procedures of the international financial institutions, and the IMF in particular, are unlikely to prove operational. They remind us why attempting to make the world a safer financial place by reforming the IFIs without at the same time reforming the broader economic and financial environment in which they operate is unlikely to succeed.