By Richard Feinberg.

THE Asian financial crisis was entirely avoidable. Throughout the past two decades, emerging market economies had experienced many similar disasters, and the causes - and cures - were well known. But vested interests and bureaucratic inertia had stood in the way of reform.

In an important new report, an expert commission assembled by the influential New York-based Council on Foreign Relations (CFR) calls for a series of reforms to prevent yet another emerging market financial blow-up.

In Safeguarding Prosperity in a Global Financial System: The Future International Financial Architecture, the 29-member commission refuses to accept that frequent, severe boom-bust cycles of international credit are inevitable. However, its recommendations will surely meet fierce resistance among those who stand to lose from reform.

The commission was assembled at the urgings of President Bill Clinton, who last September termed the Asian/global crisis "the biggest financial challenge facing the world in half a century". He asked the CFR to put together a distinguished private-sector group to study the need for reforms.

The commission membership reads like a "who's who" in United States international economic circles. The co-chairs are Ms Carla Hills, former president George Bush's trade representative, and Mr Peter Peterson, chairman of the CFR and a former secretary of commerce.

Other heavy hitters include Mr Paul Allaire, CEO of Xerox; Mr C. Fred Bergsten, president of the Washington-based Institute for International Economics; Mr George David, CEO of United Technologies; Mr Martin Feldstein, president of the National Bureau of Economic Research; Mr Maurice Greenberg, CEO of American International Group; Mr Paul Krugman, Massachusetts Institute of Technology economist; the investor George Soros, and Mr Paul Volcker, former chairman of the Federal Reserve Board.

The members of the blue-ribbon commission are Americans. Yet, the report is very concerned that current lending practices are harmful to the emerging market economies and their analysis and recommendations are tough on Wall Street. The report notes that private markets lent US$213 billion to emerging markets in 1996 but only about US$60 billion in 1998; for the five Asian crisis countries, the drop was even sharper - from a net inflow of US$65 billion in 1996 to net outflow of US$43 billion in 1998.
This US$100 billion reversal not only caused massive grief in the five debtor countries, but damaged popular faith in globalisation throughout the developing world.

NOT REWARDING BAD HABITS

The central thrust in the CFR report is to moderate the excessive volatility in private capital flows to emerging markets. The authors seek to alter the incentive structures facing both lenders and borrowers to smooth out capital flows, discourage short-term lending, and improve the quality of credit. Some of the proposals by now reflect conventional wisdom. The report concurs that emerging markets need to collect and release more data detailing their external exposures, tighten their supervisory regimes and implement internationally-sanctioned regulatory standards.

Disturbingly, the report finds that the overwhelming majority of developing countries have still not put in place the prudent debt management and liquidity requirements needed to cope with today's volatile international capital markets. The commissioners urge borrowers to improve their liquidity, reduce their currency exposure and control leverage.

Borrowers can lengthen the maturity structure of their debts and build up their stocks of international reserves. They can limit the share of new public and private debt that is denominated in foreign currency. They can subject their banks to rigorous liquidity and reserve requirements.

But the real novelty of the report lies in its focus on "moral hazard" - the provision of insurance by the official sector that weakens the sense of responsibility by investors or borrowers or both.

If the International Monetary Fund (IMF) stands ready to pump in money to bail out bad loans, lenders and borrowers have every incentive to continue to place risky bets. Lenders have had every reason to believe that no matter how flimsy their borrowers, no matter how bankrupt the borrowers' governments, the IMF would rush in to stave off default.

True to form, the international community committed US$190 billion in the official rescue packages for Thailand, Indonesia, South Korea, Russia and Brazil - forms of guarantees that the commission worries only reward bad habits. To correct for moral hazard, the commission makes two controversial recommendations.

First, IMF loans to countries in crisis should generally be smaller. Lenders will no longer feel secure that the IMF will fully cover their exposure. In particular, the IMF should not lend to support unsustainable exchange-rate pegs.

Second, when crises occur, the commissioners judge that private creditors should feel some of the pain. Such burden-sharing should apply to private credits whether extended to private banks and corporations or to sovereign governments. The report does not specify the form these losses might take, but does say that the pain should be equivalent to that suffered by other parties to the crisis.

SECURING FINANCIAL MARKETS

TO PLACE pressure on creditors to share fairly in the losses, the commissioners propose that the IMF be prepared to lend to countries even when they are in arrears on their debts to private lenders.

But the IMF should not lend unless there is a good prospect that the recipient country will achieve a sustainable debt-servicing profile. In other words, the IMF could support a government in default, but not support creditors who refuse to negotiate fair and sustainable work-out terms.

To facilitate future debt re-schedulings, the industrial countries should press banks and bond holders to form standing steering committees. To be ready for such an exercise, emerging economies should maintain a comprehensive register of their external creditors. Issuers of government bonds should include "collective action clauses" that facilitate their restructuring in the event of a debt crisis.

Thereafter, bond-holders would be bound to participate in such burden-sharing negotiations. Industrial countries should require that all government bonds issued and traded in their markets include such clauses.

Also controversial is the report's favourable review of Chile's tax on short-term international credits.

By requiring short-term creditors to place a percentage of the loan in escrow without interest, Chile has sought to discourage hot-money flows in favour of less volatile longer-term investments, with some success, reports the CFR commission.

Lenders in New York, Tokyo and London are unlikely to respond favourably to suggestions that they share the pain involved in debt work-outs. In a strongly worded dissent, commission member William Rhodes, vice-chairman of Citigroup/Citicorp, warns his fellow commissioners not to "fight yesterday's war", and not to discourage new private flows just when emerging markets are seeking to regain market access.

Mr Rhodes fears that forcing the insertion of certain types of bankruptcy clauses into sovereign bond issues could discourage flows back into the emerging markets.

He argues instead that such clauses should be implemented only case by case and on a voluntary basis on the part of both issuers and purchasers. Mr Rhodes also retorts that "in Chile, capital controls played only a minor part in the success story of that country's economy."

The other commissioners anticipate such opposition from the credit markets. Consequently, they call for a special global conference of finance ministers to press countries - creditors and borrowers - to promote financial reforms. Several commissioners want to raise such a conference to the level of heads of state - noting that despite innumerable meetings, ministers of finance have so far failed to agree on sufficient reforms to protect the world against future financial crises.
The CFR commission released its report to coincide with the end-September annual meetings of the IMF and the World Bank in Washington, DC.

It remains to be seen whether the assembled finance ministers and market players share the commission's formulae to bring greater stability to financial markets - and whether the assembled creditors accept the proposed approach to a "fair" division of the costs, should future debt crises arise.

The writer teaches international political economy at the University of California, San Diego, US. He has worked on international financial matters at the US Treasury, State Department and White House.