"Safeguarding Prosperity in a Global Financial System: The Future International Financial Architecture"

Introduction

When Thailand was forced to devalue its currency in July 1997, no one could have foreseen the turmoil that would follow. Over the succeeding two years, financial crises swept through the developing world like a hurricane. Indonesia, South Korea, Malaysia, the Philippines, Hong Kong, Russia, and Brazil were among the hardest hit, but few developing countries emerged unscathed. In the crisis countries, currencies and equity prices plummeted, economic growth turned into recession, wealth evaporated, jobs were destroyed, and poverty and school dropout rates soared. Private capital flows to emerging economies nose-dived, while industrial countries saw their export markets shrink. Last fall, after Russia’s debt default and devaluation and the near collapse of a large hedge fund (Long Term Capital Management, LTCM), international financial markets seized up for nearly all high-risk borrowers, including those in the United States. Global growth slowed sharply. In some quarters, doubts arose about the market as the engine of prosperity. Confidence in the official institutions that manage financial crises was shaken. No wonder, then, that President Clinton, speaking before the Council on Foreign Relations a year ago, characterized the Asian/global crisis as "the greatest financial challenge facing the world in the last half century."

Financial crises are nothing new. In the past 20 years alone, more than 125 countries have experienced at least one serious bout of banking problems. In more than half these episodes, a developing country’s entire banking system essentially became insolvent. And in more than a dozen cases, the cost of resolving the crisis was at least a tenth–and sometimes much more–of the crisis country’s annual national income. As bad as it was, the US savings and loan crisis of the late 1980s cost US taxpayers about 2-3 percent of our national income. The debt crisis of the 1980s cost Latin America a "lost decade" of economic growth. Ten members of the European Exchange Rate Mechanism were forced to devalue their currencies in 1992 and 1993, despite spending upwards of $150 billion to defend them. Mexico suffered its worst recession in six decades after the devaluation of the peso in 1994-95. And in the recent Asian crisis, economies accustomed to annual growth rates of 6-8 percent suffered severe depressions, with output falling 5 to 14 percent last year. In the past six months, a number of the crisis countries have returned to positive economic growth and the functioning of global financial markets has improved. But the global recovery is still in its early stages and remains fragile—not least because most of the underlying vulnerabilities have been only partly addressed.

We cannot eliminate banking, currency, and debt crises entirely, but it would be a counsel of despair to argue that little can be done to make them less frequent and less severe. Strengthening crisis prevention and management–that is, the international financial architecture ("the architecture" for short)–is also very much in our national interest. The US economy is connected much more closely to the rest of the world than it was 20 or 30 years ago. The average share of exports and imports in our national output now stands at about 15 percent–twice as high as in 1980 and three times as high as in 1960. Two-fifths of our exports go to developing countries. US firms active in global markets are more productive and more profitable than those that serve only domestic customers. Exporting firms pay their workers better and have expanded jobs faster than firms that do not export. More than $2.5 trillion of US savings is invested abroad. Borrowing costs, including the monthly payments US households make for their home mortgages, are lower because of our participation in international capital markets.

But why worry, some might ask. After all, the US economy has continued to perform impressively throughout the latest crisis period. So it has. But to conclude that fragilities in the international financial system are somebody else’s problem would be dangerously complacent. In the recent emerging-market crisis, US exports to the most affected areas fell 40 percent. The Asian crisis struck when domestic spending in the United States was robust and when inflationary pressures were low. This meant that our economic growth was able to withstand a big jump in the trade deficit and that the Federal Reserve had scope to calm the turbulence in global markets by cutting interest rates. Next time we might not be so well positioned to weather the storm.

We should also take note of events that did not happen but could have. Americans have more of their wealth invested in the stock market than they have in their homes. The Asian crisis could have acted as a catalyst for a significant stock market correction.

The United States is not immune to financial crises abroad. There have been enough losses, close calls, and "might-have-beens" over the past few decades to remind us that international capital markets—despite their important contribution to our standard of living—can at times be risky places. The more successful we are in reducing the frequency and severity of financial crises—including in emerging economies—the better are our chances of safeguarding America’s jobs, savings, and national security as well as of promoting global prosperity.

Our Approach

If we are to make real headway in improving crisis prevention and management in the developing world, we must put the primary responsibility back where it belongs: on emerging economies themselves and on their private creditors, which dominate today’s international capital markets. If the behavior of debtors and creditors does not change, the poor track record on financial crises will continue. But wishing for change will not make it happen. Better incentives—including the prospect of smaller and less frequent official bailouts—can facilitate desirable changes in lender and borrower behavior.

Six principles guided our analysis. We wanted to:

1.Encourage emerging economies to intensify their crisis prevention efforts. 2.Permit savings to flow to the countries and uses where they have the best return.
3.Promote fair burden-sharing among private creditors, official debtors, and official creditors when a crisis does occur.
4.Increase the role of market-based incentives in crisis prevention and resolution. 5.Make reform of the architecture a two-way street, with the major industrial countries also doing their part.
6.Refocus the mandates of the IMF and the World Bank on areas they are best equipped to address.

Consistent with these principles, we offer seven key recommendations:

Recommendation 1. Greater rewards for joining the "good housekeeping club." The IMF should lend on more favorable terms to countries that take effective steps to reduce their crisis vulnerability and should publish assessments of these steps for each country so the market can take note.

Recommendation 2. Capital flows—avoiding too much of a good thing. Emerging economies with fragile financial systems should take transparent and nondiscriminatory tax measures to discourage short-term capital inflows and encourage less crisis-prone, longer-term ones, such as foreign direct investment.

Recommendation 3. The private sector: promote fair burden-sharing and market discipline. To encourage more orderly and timely rescheduling of private debt where it is needed, all countries should include "collective action clauses" in their sovereign bond contracts. In extreme cases where rescheduling of private debt is needed to restore a viable debt profile, the IMF should require as a condition for its own emergency assistance that debtors be engaged in "good faith" (serious and fair) discussions on debt rescheduling with their private creditors. The IMF should also be prepared to support a temporary halt in debt repayments.

To reduce moral hazard at the national level, the IMF should encourage emerging economies to implement a deposit insurance system that places the primary cost of bank failures on bank shareholders and on large, uninsured private creditors of banks–and not on small depositors or taxpayers.1.

Recommendation 4. Just say no to pegged exchange rates. The IMF and the Group of Seven (G-7) should advise emerging economies against adopting pegged exchange rates and should not provide funds to support unsustainable pegs.

Recommendation 5. IMF crisis lending: less will do more. For country crises, the IMF should adhere consistently to normal lending limits. This will help to reduce moral hazard at the international level. For systemic crises, the IMF should turn to its existing credit lines when problems are largely of the country’s making and to special contagion funds when the country is an innocent victim.

Recommendation 6. Refocus the IMF and the World Bank: back to basics. The IMF should focus on monetary, fiscal, and exchange rate policies plus financial-sector surveillance and reform and stay out of longer-term structural reforms. The World Bank should focus on the longer-term structural and social aspects of development, including the design of social safety nets. It should stay out of crisis lending and management. Recommendation

7. Generate political support for and ownership of financial reforms. Convene a global conference of finance ministers to reach a consensus on actions, priorities, and timetables for actions nations will take to strengthen national financial systems.

The Reform Agenda

Recommendation 1. Greater Rewards for Joining the "Good Housekeeping Club"
Emerging-market economies have a key responsibility to keep their houses in order, and the international community can encourage them to do so by enlarging the rewards for good housekeeping.

"Good housekeeping" covers a range of economic policies and institutional reforms. It means pursuing sound macroeconomic policies, including the avoidance of large budget deficits. It means prudent debt management that does not permit liquid liabilities of the public and private sectors to get way ahead of their liquid assets and that discourages the buildup of large currency mismatches. It means not being complacent about large current account deficits and highly overvalued exchange rates. It means maintaining a strong and well-regulated banking and financial system that extends loans on the basis of their expected profitability and of the creditworthiness of the borrower, and that complies with international standards for good public disclosure of economic and financial data, for effective banking supervision, and for the proper functioning of securities markets. It means shunning heavy reliance on short-term borrowing and on longer-term debt contracts with options that allow the creditor to demand accelerated repayment if conditions worsen. And it means holding enough international reserves and arranging contingent credit lines so that there is enough liquidity on hand to cushion against unexpected adverse shocks.

Suffice it to say that many of these elements of good housekeeping were not in order in the run-up to recent crises. In Russia and Brazil, for example, large government deficits and heavy reliance on short-term government borrowing were at the heart of their vulnerability.

In the Asian crisis countries, imprudent debt management, weak domestic banking systems, and premature and poorly supervised financial liberalization took a heavy toll when the external environment soured. Encouraged by interest rates lower abroad than at home, by exchange rates that had been relatively stable with respect to the US dollar, and by a history of strong economic growth, banks and corporations in the crisis countries stepped up their short-term foreign borrowing in the 1990s, much of which had to be repaid in foreign currency. On the eve of the crisis, short-term external debt was larger than international reserves in several of the crisis countries, and corporations had very high debt-to-equity ratios. Banks and finance companies in these countries had lax lending and accounting standards. Their lending decisions were also compromised by heavy government interference and by high levels of "connected" lending (to bank managers and directors and their related businesses). Bank supervision was weak. Reflecting all this, borrowed funds were not invested wisely, with heavy concentrations in real estate, equities, and industries with low rates of return. Lenders (domestic and foreign) did not monitor borrowers carefully, perhaps because they expected that governments and international organizations would be willing and able to bail them out if borrowers ran into trouble.

And run into trouble they did. Exports from Asia slowed dramatically in 1996, prompted by a steep decline in semiconductor prices and a loss of competitiveness as Asian currencies followed the US dollar up against the Japanese yen. Property prices fell, leading to a surge in nonperforming bank loans. As foreign lenders began to recognize that Thailand’s weaknesses were shared by several other Asian emerging economies, a panic ensued in which foreign shareholders, bondholders, and banks scrambled to get their money out. Cash flow problems mounted as interest rates rose in vain attempts to defend currencies pegged to the dollar. Political instabilities and uncertainties added to the problem. And when currencies fell sharply, this made it much more expensive for companies to repay their foreign currency loans. Soon everything collapsed.

Henceforth, the IMF should lend on more favorable terms to countries that take effective steps to reduce their vulnerability to crises. To increase the private market payoff for good crisis prevention, the IMF should make public a "standards report" in which it assesses periodically each member country’s compliance with international financial standards. It should also publish its regular assessments of each country’s economic policies and prospects (its Article IV reports). Loans to countries that make the extra crisis prevention effort should benefit from lower regulatory capital requirements for banks. Some initial, partial, and tentative steps in this general direction have already been made, but more should be done to strengthen the rewards for joining the "good housekeeping club."

Recommendation 2. Capital Flows–Avoiding Too Much of a Good Thing
The freer flow of capital across national borders has been of considerable benefit to the world economy. It has loosened the constraints imposed by self-financing and improved the overall productivity of investment on a global scale. This finances development and raises living standards in borrowing countries while providing savers in lending countries with the opportunity to earn a better return on their money. It has permitted both borrowers and investors to obtain better diversification against shocks to their domestic economies. It has helped foster the transfer of best-practice production processes.

But experience indicates there are risks and costs along with the benefits. In recent years, private capital flows into emerging markets have been highly volatile. After mushrooming in the early 1990s, they reached a peak of $213 billion in 1996, before collapsing to just over $60 billion last year. This volatility shows up in price as well as quantity. During the 1990s, the interest rates paid on emerging-market bonds have fluctuated wildly in comparison with those paid on US bonds. For example, this interest rate spread was 1,200 basis points in January 1991; 400 points in January 1994; 1,600 points in January 1995; 400 points in mid-1997 (just before the Asian crisis began); 1,400 points in the fall of 1998 (just after Russia’s debt default); and 1,100 points in July 1999.2.

While some fluctuation in private capital flows to emerging economies is natural in light of changing investment opportunities and the way investors react to new information, experience suggests that "boom and bust" cycles in such flows create serious problems. When capital inflows are very large and occur at a pace that outstrips the domestic capacity to supervise the financial sector and to build a credit culture, they sow the seeds of subsequent banking crises. In several of the Asian crisis countries, the recent crisis was preceded by bouts of premature and poorly supervised financial liberalization. In Thailand, for example, the Bangkok International Banking Facility—although intended for another purpose—wound up serving as a conduit for local firms to vastly expand their loans from foreign banks, with unhappy results.

Turning to the "bust" side of the cycle, a sudden stop or reversal in private capital flows is often the forcing event that ushers in a crisis. This can turn liquidity problems into solvency problems, induce large cuts in spending that bring on recession, and spread crises considerably beyond their origin. For five Asian emerging economies heavily affected by the recent crisis, net private capital flows went from a net inflow of $65 billion in 1996 to an outflow of $43 billion in 1998; Japanese banks alone withdrew $21 billion from these five countries in 1997 (versus a $50 billion inflow the preceding year).

The challenge, therefore, is to find ways to moderate the boom-bust cycle in private capital flows and to tilt the composition of such flows toward longer-term, less crisis-prone components (such as foreign direct investment) while still preserving most of the benefits associated with greater market access.

Short-term capital flows carry a high risk because their short maturity makes it easier for investors to run at the first hint of trouble. Whereas net flows of foreign direct investment to emerging economies recorded only a slight decline during the recent Asian crisis, the fall in portfolio flows and even more so in bank loans was much more pronounced. Chile has addressed this problem by, in effect, taxing capital inflows if they are withdrawn after only a short time. This seems to have tilted the composition of its inflows toward the less risky, longer-term components. Admittedly, the effectiveness of such measures does tend to erode over time, and one side effect is that some desirable short-term flows—such as credits to support trade—can also be deterred. Nevertheless, if the alternative is a boom-bust cycle followed by a costly financial crisis, the choice seems clear.

The IMF should therefore advise those emerging economies with fragile domestic financial sectors to impose Chile-type holding-period taxes on short-term inflows until their ability to intermediate such flows is stronger. The measures should be transparent and designed not to impede the entry of foreign financial institutions, which can make a valuable contribution to strengthening domestic financial systems.

There are other things that can also be done to moderate the boom-bust cycle. For one, emerging economies should not impose controls or taxes on long-term inflows. One reason South Korea relied so heavily on short-term inflows was that it had controls that kept long-term flows out. For another, in revising the international agreement that specifies how much capital internationally active banks need to hold against various kinds of assets (the Basle Capital Accord), regulators should avoid weighting schemes, which provide incentives for short-maturity flows.

Hedge funds, which finance often very short-term investment decisions with huge sums of borrowed money, have a gained a certain notoriety in financial crisis episodes. But a review of these episodes—including the recent events in Asia—suggests that hedge funds are not the villains they are often made out to be. At the same time, given the threat highlighted by the near-collapse of LTCM last year, the official community is right to step up the "indirect" regulation of hedge funds by tightening risk-management guidelines for the banks and security houses that lend to them. Financial regulators should give this approach a fair trial. But if it does not produce results, they should consider going farther by imposing a higher regulatory capital charge (risk weight) for bank loans that go to offshore financial centers (where many hedge funds are located) that do not meet international financial standards.

Recommendation 3. The Private Sector: Promote Fair Burden-Sharing and Market Discipline
If a country faces an unsustainable burden of debt repayments, inevitably they will have to be rescheduled. It benefits neither debtor nor creditors if this takes a long time. But there are formidable institutional barriers to a quick resolution. There is no international bankruptcy code, and in many developing countries national bankruptcy laws either do not exist or function poorly. There are mechanisms through which debts payable to governments can be rescheduled cooperatively, but there is no equivalent for debts to the private sector.

If debt difficulties are resolved with large official bailouts—be it by national authorities or by the international financial institutions—then there will be problems of a different but equally serious nature. If market participants come to routinely expect such bailouts, then private creditors will have little incentive to monitor the financial condition of borrowers, too many resources will be channeled to the borrowers and lending categories viewed as implicitly "insured," and taxpayers and legislatures in creditor countries may withdraw their support for such rescues because they are being asked to bear the consequences of poor lending and borrowing decisions by other parties. One reason it was so difficult to secure approval from Congress for an increase in the IMF’s financing last year was the perception that Wall Street—and particularly, large banks—was benefiting much more from official rescue packages than was Main Street.

These problems generally fall under the heading of "moral hazard." As with other types of insurance, the appropriate responses to moral hazard are to limit the size of insurance payments and to charge risky policyholders more for the insurance—not to provide no insurance at all.

Problems with debt rescheduling and with moral hazard have become more pressing in recent years. The share of bonds in emerging-market financing has increased sharply while that for bank loans has declined. Bonds are "rescheduling unfriendly" compared to bank loans. For government bonds, one solution would be to include clauses in contracts to make it harder and less profitable for rogue creditors to impede a rescheduling; such "collective action clauses" already are included in syndicated bank loans. Successive reports by groups of industrial-country governments have in fact recommended such collective-action clauses. But it is unrealistic to expect emerging-market countries to take this step on their own if highly creditworthy industrial countries refuse to join in or to make it worthwhile to do so.

On the moral hazard front, significant difficulties exist at both the national and international levels. At the national level, the past several decades have witnessed rapid growth in the banking and financial sectors of emerging economies. Yet the vast majority of these countries do not have in place a good system of deposit insurance for their banks. Such a system should put the burden of resolving failed banks on shareholders and on large, uninsured creditors rather than on small depositors and taxpayers or on international institutions; it should place stringent accountability conditions on senior economic officials when they decide to rescue a bank because it is "too large to fail"; and it should give bank supervisors protection against strong political pressures to delay taking corrective actions. This is the kind of deposit insurance reform that was introduced in the United States after our savings and loan crisis. Without such reform, those most responsible for causing banking crises often get off the hook while others pay the tab.

At the international level, it is true that equity investors and bond holders experienced large losses in the Asian crisis, and banks took sizable hits from the Russian crisis. But too often, large rescue packages allow private creditors—particularly large commercial banks—to escape from bad lending decisions at relatively little cost. The $50 billion Mexican rescue package of February 1995 allowed holders of certain Mexican government securities (tesobonos) to get out whole. The international community committed about $190 billion in official rescue packages for Thailand, Indonesia, South Korea, Russia, and Brazil, one-third of which has so far been disbursed. The Miyazawa Plan has committed $30 billion more to Asian rescue packages. The Thai, South Korean, and Indonesian authorities issued broad guarantee announcements for bank depositors and creditors shortly after the outbreak of their crises, and the bulk of the rescheduling of the short-term debt of South Korean banks was done with a government guarantee.

One need look no further than private capital flows to Russia and the Ukraine in the run-up to the crisis–widely known on Wall Street as "the moral hazard play"—to see what happens when moral hazard effects become large. Despite serious underlying weaknesses in the economic fundamentals, investors were prepared to purchase large amounts of high-yielding government securities, presumably under the expectation that should conditions worsen, geopolitical and security concerns would prompt G-7 governments and the IMF to bail them out.

To be sure, when official rescue packages are evaluated, a balance must be struck between limiting systemic risk and encouraging market discipline. By providing emergency assistance to an illiquid but not insolvent borrower and thereby preventing a costly default and its possible spillover to other borrowers, an official crisis lender can limit the risk to the financial system as a whole. On the other hand, if such emergency assistance is too readily available, too large, and too cheap, lenders will not learn the lessons of their mistakes and market discipline will suffer. But in recent years that balance has tilted too far away from market discipline. Unless balance is restored, we will not be successful either in deterring future crises or in garnering popular support for official rescue packages.

To bring more order and timeliness to private debt rescheduling, all countries—including the G-7—should include collective-action clauses in their government bond contracts. The G-7 should match its words with actions by also requiring that all government bonds issued and traded in their markets include such clauses.

The IMF should encourage emerging economies to maintain comprehensive registers of their creditors. Creditors in turn should be encouraged to form standing committees that could help coordinate future debt reschedulings.

To reduce moral hazard at the national level, the IMF should advise emerging economies to enact sensible deposit insurance reform in their banking systems. At the international level, the IMF should provide emergency assistance only when there is a good prospect of resolving the applicant country’s underlying balance of payments and debt problems. In the extreme cases when this requires rescheduling of private debt, the Fund should make "good faith" discussions on such rescheduling a condition for its own assistance and should be prepared to support a temporary halt in debt repayments. No category of private debt (including bonds) should be exempt from such rescheduling, and it should be done in a way that does not discriminate between domestic and foreign creditors.

Recommendation 4. Just Say No to Pegged Exchange Rates
One of the most important steps an emerging economy can take to reduce the risk of a crisis is to get its exchange rate policy right. The events of the past two years have highlighted the risks of trying to defend a currency regime based on a publicly announced exchange rate target, and especially so for "adjustable peg" regimes (that is, a regime in which an emerging economy pegs its currency to the currency of a larger economy—usually the US dollar—with an option to adjust the peg when underlying conditions change). Thailand, Malaysia, the Philippines, Indonesia, Russia, and Brazil have all been forced to abandon announced exchange rate targets during the recent emerging-markets crisis. Among larger emerging economies with open capital markets, the list of those that have been able to maintain a fixed exchange rate for five years or more is now very short: Argentina and Hong Kong.

Pegged exchange rates have their attractions. They can be an effective instrument for reducing high inflation. But the potential risks of pegged exchange rates—particularly their vulnerability to crises—the benefits. Pegged rates become problematic when they become highly "overvalued." This can happen either because the country’s inflation rate (even if it is much reduced from earlier periods) remains higher than that of its trading partners, or because the currency to which it is pegged is rising and is dragging it up against other currencies. In either case, a highly overvalued exchange rate translates into poor competitiveness, making the currency a target for speculators. But there is no easy way to exit gracefully from a pegged exchange rate: when the overvaluation is small, there is apt to be little political support for upsetting the applecart with a change in the pegged rate, and by the time the overvaluation has become large and obvious, it is often too late to avoid a crisis.

Once a country runs low on international reserves, the brunt of the defense of a pegged exchange rate falls on high domestic interest rates (to make assets denominated in its currency more attractive). But high interest rates slow economic growth and raise unemployment, make things worse for fragile banking systems, exacerbate the fiscal problems of governments with large fiscal deficits and lots of floating-rate debt, and add to the cash flow problems of highly leveraged corporations. Speculators, many of whom can finance very large positions in the foreign exchange market, know that there is a limit to how long countries can keep interest rates sky-high. In most of these battles, David and his sling (that is, his fixed exchange rate and high interest rates) have been crushed by Goliath (the international capital market), and it is not easy to see why this asymmetry would disappear over the foreseeable future.

In some recent crises (for example, Brazil and Russia in 1998-99, Mexico in 1994-95, and some member countries of the European Exchange Rate Mechanism in 1992-93), exchange rate overvaluations were sizable. In the case of the Asian crisis countries, their currencies appeared to be only modestly overvalued in mid-1997, but large current account deficits, sharply falling export growth, weak banking systems, and highly leveraged corporations made them vulnerable. In addition, because their exchange rates had been relatively stable for a long time, banks and corporations did not protect themselves against currency risk, and hence the consequences of large foreign currency exposure were that much more painful when large devaluations finally occurred.

None of this is to claim that other currency regimes are not without their own problems. Rather, it is simply to argue that an adjustable peg regime seems particularly crisis prone for emerging economies.

Despite the risks, history suggests that emerging economies will be tempted to defend an overvalued pegged exchange rate if IMF and G-7 funds are available to finance that defense. The IMF and the G-7 therefore should go beyond advising emerging economies not to adopt an adjustable peg regime. If asked to support an unsustainable peg, the Fund and the G-7 should "just say no." The mainline currency recommendation for emerging economies should instead be one of "managed floating," with the use of currency boards and single currencies reserved for particular situations.

Recommendation 5. IMF Crisis Lending: Less Will Do More
The International Monetary Fund was created to help countries tackle balance of payments problems without resorting to draconian austerity measures, beggar-thy-neighbor exchange rate policies, and trade barriers. This remains an extremely valuable goal. Indeed, as costly as the recent emerging-market crises have been, we would have seen deeper recessions, more competitive devaluations, more protectionism, and far more human suffering had there been no financial support from the IMF and from other official creditors.

But this does not mean the bigger the better. Rescue packages for country crises should be large enough to reduce the recessionary impact of the crisis, to finance some smoothing operations in currency markets, to contribute modestly to the cost of bank restructuring, and to provide a social safety net that provides some protection against the hardships of the crisis for the most vulnerable groups in the economy. In the overwhelming majority of cases, the Fund’s normal lending limits (100 percent of a country’s quota or IMF subscription annually and 300 percent of quota cumulatively) ought to be sufficient. Rescue packages should not be so large as to provide cover for holders of short-term external debt to escape the consequences of poor lending decisions—lest they generate the kind of moral hazard problems emphasized above. IMF loans to Mexico (1995), to Thailand and Indonesia (1997), and to Brazil (1999) were in the neighborhood of 500-700 percent of Fund quotas, while the loan to South Korea (1997) was 1,900 percent of its quota.

We are not persuaded that smaller rescue packages would necessarily make it more difficult for emerging economies to regain the "confidence" of investors, as experience suggests that this owes more to the speed and determination with which underlying economic problems are addressed. The expectation of smaller rescue packages may well reduce somewhat the flow of private external finance to emerging economies and increase somewhat its cost. But since interest rate spreads on emerging-market borrowing have been too low and the flow of capital to them too high during much of the 1990s, some moderate movement in the other direction would be no bad thing (especially for those emerging economies with relatively high domestic savings rates).

But what about rare situations of widespread cross-border "contagion" of financial crises where failure to intervene would threaten the performance of the world economy and where private capital markets are not distinguishing well between creditworthy and less creditworthy borrowers?

To counter such systemic threats effectively, the international community needs quick access to an adequately and securely funded international backup facility that can assist the victims of contagion. This would supplement the existing credit lines (the New and General Agreements to Borrow, or NAB/GAB) that the IMF already has available from a set of creditor countries. In April 1999 the IMF established a new lending window, the Contingency Credit Line (CCL), to offer assistance to well-behaved countries that feel threatened by contagion. But the CCL contains no new money and its operational guidelines seem unnecessarily complex.

We propose that the IMF return to normal lending limits (100-300 percent of quota) for country crises, that is, for crises that do not threaten the performance of the world economy. In the unusual case of a systemic crisis, the IMF should turn to its systemic backup facilities–either the existing NAB/GAB or a newly created "contagion facility" that would replace the existing Supplemental Reserve Facility (SRF) and the CCL. Activation of the systemic facilities would require a decision by a supermajority of creditors. The NAB/GAB would be used when the country’s problems are largely of their own making and an IMF program is needed to correct those problems. The contagion facility would be used for victims of contagion. Loans from the contagion facility would be agreed on expeditiously, would be disbursed quickly, would be free of policy conditions, and would be priced more expensively than normal loans from the Fund. This contagion facility would be funded by pooling a one-off allocation of Special Drawing Rights–the IMF’s artificial currency.3. The US contribution to that contagion facility would be made after extensive consultation with the Congress.

Recommendation 6. Refocus the IMF and the World Bank: Back to Basics
The emerging-market crises have shaken public confidence in the Bretton Woods institutions. But their roles are crucial—the Fund as a key crisis lender and manager and also increasingly as a monitor of compliance with international financial standards, and the World Bank as a promoter of poverty reduction and sustainable economic development.

Calls for their abolition are misplaced. There is a moral hazard problem associated with large IMF-led financial rescues, but this can be reduced significantly by altering the IMF’s lending policies along the lines sketched above. Although hindsight reveals that the Fund’s monetary and fiscal policy recommendations to the Asian crisis countries were by no means flawless, these are best regarded as judgment calls in a difficult situation in which there were no easy solutions. For example, while an earlier move to lower interest rates would have helped counter the recession by reducing debt burdens and cash-flow vulnerabilities, it carried the risk of accelerating currency depreciation in a context in which banks and corporations had large, unhedged foreign-currency liabilities and confidence was already very weak.

But to reject the abolition of these institutions is not to deny that there is a need for reform of the Bretton Woods twins. Both the Fund and the Bank have tried to do too much in recent years, and they have lost sight of their respective strengths. They both need to return to basics.

We argue that the Fund should normally lend less and concentrate more on encouraging crisis prevention. It should also focus on a leaner agenda of monetary, fiscal, and exchange rate policies, and of banking and financial-sector surveillance and reform. It should leave more detailed structural reforms to the World Bank and other international organizations with the requisite expertise in those areas.

The World Bank, in turn, should focus on the longer-term structural and social aspects of economic development. It should not be involved in crisis lending or crisis management, and it should refrain from publicly second-guessing the Fund’s macroeconomic policy advice.

One area where the Bank can and should do more is in the design of social safety nets. When crises strike, the burden of economic adjustment usually falls hardest on those least able to cope. The recent crises in Asia have provided fresh affirmation of this danger, and the need to protect the poorest and most vulnerable would be even more pressing if official rescue packages became smaller in the future. While this report concentrates on the financial architecture and on the role of the IMF, it is well to remind ourselves that financial stability is not an end in itself but rather a means to broadly shared global prosperity and that it is a fantasy to believe that financial stability can be maintained without attention to the social aspects of development.

Recommendation 7. Generate Political Support for and Ownership of Reforms
Many of the cracks in the international financial system reflect weaknesses in national policies. Remedying these defects–be it by strengthening financial systems in emerging economies or by altering some institutional practices (for example, collective-action clauses in bond contracts) in industrial economies–might be unpopular and will on occasion demand that powerful vested interests be confronted. In addition, experience suggests that reform programs are most successful when the countries most affected participate directly in the design of those measures and when they take "ownership" of the reforms. If the emerging economies are not full partners in the reform exercise, it will not work.

Intensive discussions on strengthening the financial architecture have been under way for about five years (since the Mexican peso crisis of late 1994). With prospects for recovery from the global crisis brightening, there is a danger that "architecture fatigue" and complacency could combine to stall the push for reform—and this before most of the measures set out in this report could be implemented.

For all these reasons, governments will have to demonstrate considerable political will to carry the reform agenda through. To help foster the necessary political commitment, the international community should directly involve the nations whose behavior we wish to change. The IMF’s Interim Committee, the Financial Stability Forum, and the presidents of the regional development banks therefore should convene a special global meeting of finance ministers to establish priorities on architectural reform measures and to agree on a specific timetable for specific corrective steps.

Conclusion

Many of the themes emphasized in this report have also been part of the official sector’s plans and suggestions for the future architecture. Nevertheless, our approach differs from theirs in several important respects:

•We believe in stronger measures to reduce moral hazard and encourage market discipline, and in particular to induce private creditors to accept their fair share of the burden of crisis resolution. •We believe that the IMF should return to more modest rescue packages for country crises and that large rescue packages should occur only in systemic cases with the agreement of a supermajority of creditor countries. •We believe that the IMF and the G-7 should take a harder line on limiting official support for adjustable peg currency regimes, and that the Fund should be more active in identifying publicly which countries are and are not meeting international financial standards. •We are more forthright in advocating tax measures to shift the composition of capital inflows in emerging economies to longer-term, less crisis-prone elements. •We believe that the major industrial countries should be more willing to take the lead in enacting certain institutional reforms in capital markets. •We prefer a simpler and more adequately funded backup facility to deal with systemic episodes of contagion of financial crisis. •We propose a stricter demarcation of responsibilities and leaner agendas for the IMF and the World Bank. •We suggest a vehicle for garnering political support and establishing a timetable for architectural reform.

The recommendations outlined in the report are those that were able to command majority support within the task force. Many other proposals, however, were actively debated. A large group of task force members felt that there could be no serious reform of the architecture without fundamental reform of G-3 currency arrangements. They argued that the impact of the global economy on emerging economies is driven significantly by swings among the G-3 currencies, and that in recent years these swings have been enormous, volatile, and frequently unrelated to underlying economic fundamentals. They favored a system of rather broad target zones or reference ranges for the dollar, the euro, and the yen. Some other task force members favored stronger regulation over highly leveraged institutions; a global summit on architectural reform to be held by heads of state and governments; greater incentives for crisis prevention and greater use of early warning indicators of financial crises; a more structural approach to reform of the architecture; a link between core labor standards and international financial standards; a different approach to collective-action clauses in bond contracts, to taxes on capital inflows, and to private-sector burden-sharing; or new measures to encourage sound long-term lending to emerging economies.

We also discussed more radical alternatives. These included comprehensive controls on capital flows, the adoption of single currencies, more far-reaching reforms of the IMF (ranging from its abolition to the creation of a much larger and more powerful Fund), and the establishment of new, supranational regulatory institutions. In the end, the more radical proposals seemed either undesirable or impractical. We therefore opted instead for what we would characterize as "moderate plus" proposals: proposals that, taken together, would make a significant difference to crisis prevention and management but that would still have a reasonable chance of acceptance.
 

The Institute for International Economics (An independent task force sponsored by the Washington-based Council Of Foreign Relations)