In Crisis Prevention and Resolution
(For the Seminar on March 11, 1999)
The world economy of today is considerably different from that of fifty years ago when the International Monetary Fund was established. At that time the world economic system was based on the idea of free trade and free current exchange transactions with limited capital flows and fixed exchange rates. Today the world economy is faced and struggles with abrupt large scale cross-border capital movements and their effects on exchange rates. In order to prevent and resolve modern international financial crises, it is necessary to fully recognize these current economic conditions and to adapt the Fund to them.
I Crisis Prevention
Fund surveillance and programs, following the tradition since the Fund's establishment, have placed much emphasis on fiscal and monetary restraints compatible with current account adjustments. However, in light of the fact that one of the major causes of today's financial crises is rapid changes in the size and direction of capital flows, it is necessary to strengthen Fund surveillance, especially of emerging economies, by paying more attention to safeguarding these economies against large and rapid capital movements. Fund surveillance should therefore emphasize, in addition to the areas of fiscal and monetary policies, a) safeguards against capital movements; b) exchange rate policy; and c) a better grasp of the real economy of members.
A. Safeguards Against Capital Movements
1. Monitoring of Capital Flows
It is imperative to strengthen the monitoring of capital flows when conducting surveillance. The Fund and national authorities, with the assistance of relevant institutions such as the BIS, should create more detailed data on inflows and outflows of capital by maturity, currency, type (direct investment, bank borrowing, securities investment, etc.), and borrower (sovereign, financial institution, private corporation, etc.).
Data on creditors (i.e., private sector) as well as debtors (i.e., emerging economies) are necessary for the proper monitoring of capital flows. It is therefore worth considering the establishment of an informal consultation process for the purpose of information exchange between the Fund and private sector financial institutions involved in international capital flows. In this connection, the activities of highly leveraged institutions (HLIs) such as hedge funds need to be made more transparent.
The Fund staff should provide the Executive Board with detailed information obtained through the above-mentioned process so that at Article IV consultation discussions the Board can conduct a thorough examination and analysis of capital flows and debt structures of emerging economies, including their policy implications.
2. Management of Capital Flows
For emerging economies, foreign exchange reserves are the most basic means to cope with crises. It is therefore important to limit the aggregate volume of short-term borrowing from overseas creditors to a level that is manageable under a country's reserves. This can be achieved through careful monitoring of capital flows and, in particular, management of short-term capital inflows. In this context, it may be appropriate to examine the concept of the usability of foreign exchange reserves.
Prudential regulations need to be reinforced, when necessary, and regulations which address capital inflows need to be utilized, as long as they are designed in a market-friendly way.
It must be clearly recognized that capital account liberalization should be carried out when appropriate conditions are met, in a well-designed sequence.
3. Private Sector Involvement
The Fund should encourage emerging economies to adopt measures to ensure private sector involvement in crises, such as contingent credit arrangements and collective action clauses.
4. Surveillance of Financial Sectors
Strong financial sectors are indispensable for emerging economies to withstand the effects of capital movements. The Fund needs to strengthen its surveillance of the financial sector issues of, and supervision of these sectors by, member countries through, for example, monitoring of each member's degree of compliance with internationally agreed financial sector standards, such as the Basle Core Principles.
As for the implementation of financial sector reform, the World Bank and/or other international institutions with relevant expertise should take the lead.
B. Exchange Rate Policy
The most appropriate exchange rate regime may differ from one country to the next, due to conditions specific to each country, such as the scale of the economy, trading partners, use of capital controls, etc. The Fund should monitor the situation of each currency, including developments in the real effective exchange rate, asset prices, and capital account balances, so that it can advise the country on exchange rate policy, including exit policy from pegged regimes.
In the case of emerging or developing economies, it might be generally appropriate for them to peg their currencies to a basket of currencies of the developed countries with which they have the closest trade and investment interdependence, adjusting the peg periodically to reflect developments in real effective exchange rates and current and capital account balances among other things. There is no simple set formula, however, and case-by-case perusal of countries' specific situations is essential.
It is also necessary to promote further stability of exchange rates among the major currencies against which currencies of emerging economies would be pegged.
C. Better Grasp of the Real Economy
The experience of recent Fund programs has revealed cases in which monetary and fiscal restraints based on overly ambitious growth outlooks have led to an overkill of economic activity. This strongly suggests a need for a more realistic grasp of a country's overall economy.
In conducting surveillance and formulating programs, emphasis should be placed on understanding a country's overall economic situation, as opposed to the present approach ('financial programming') which relies too heavily on monetary elements. The Board should make a full analysis of the country's real economy including the development of major industries and prospects of demand by component. Full utilization of input from representative offices will be required.
II Crisis Resolution --- Improving the Effectiveness of Programs inCrises
The recent experience of crises has made it clear that the design of Fund programs, especially for crisis-hit countries, should be reviewed. To achieve this, in addition to a better grasp of the real economy mentioned above, the Fund should focus on the fields where it has the greatest expertise, namely: a) safeguards against capital movements; b) exchange rate policy; c) fiscal policy; and d) monetary policy. It is also necessary to limit the Fund' s involvement in structural policies.
Furthermore, as a longer-term challenge consideration should be given to enhancing the Fund's lender of last resort function.
A. Safeguards Against Capital Movements (PrivateSector Involvement)
Private sector involvement in crisis resolution is a key question that needs to be discussed thoroughly. It suffices here to point out that enhancing private sector involvement in crisis resolution is critical, considering the fact that recent crises, and the overheating of economies that led to these crises, were brought about mainly by private sector activity, and that bailing out private investors by means of financial assistance from official sources, in particular the Fund, is not justified from the viewpoint of fairness and moral hazard.
At times of crisis, it might be appropriate to make Fund programs for financial assistance conditional on the maintenance of exposure, with measures such as those mentioned in Paragraph 9 above, and/or on an agreement to rollover loans from major private sector creditors.
Measures such as introducing controls on capital outflows of residents and a temporary standstill of foreign liabilities owed by public as well as private sector borrowers should be legitimized as possible options, depending on the situation. In this connection, the Fund should move ahead with the policy of lending into arrears. Needless to say, care must be taken that such controls do not restrict current transactions, as opposed to capital transactions, or undermine investor confidence.
B. Exchange Rate Policy
When a fixed exchange rate is deemed excessively high, it is advisable not to try to maintain the rate at all costs but to devaluate the currency at the earliest possible opportunity and/or to float the currency.
While monetary tightening has been used in many cases for the purpose of defending an exchange rate, such a policy needs to be used with caution. Once investor confidence in a currency is lost, monetary tightening may have limited effects on defending the exchange rate. On the other hand, tight monetary policy and the resulting high real interest rates would have an adverse effect on a country's economic activity and fiscal position.
C. Fiscal Policy
Countries which have good track records and which have not had significant budget deficits or current account deficits in the past should not be required to implement too strict a fiscal policy immediately after a crisis. The unavoidable expansion of budget deficits after a crisis should be addressed as a medium- to long-term challenge to be tackled once the situation stabilizes.
D. Monetary Policy
As for monetary policy after a crisis, it is important to recognize that there are cases where the Fund should shift priority to providing liquidity to the domestic economy to mitigate the deflationary impact of the crisis.
In order to avoid a situation where liquidity injected in connection with a Fund program leads to additional capital outflows and a decline in reserves, measures such as the introduction of controls on capital outflows of residents should be considered.
With regard to inflation-targeting as a replacement for the exchange rate anchor, one needs to recognize its deflationary effects on an economy. As the experience of the Asian crisis shows, the real risk for a crisis country is contraction of the economy, not inflation. Increases in the prices of imported goods on the general price level are a one-time effect and can be accommodated. In a crisis situation, particularly when the soundness of the financial sector is in question, the public's increased preference for liquidity may change the function of demand for money. For these reasons one should be mindful that inflation-targeting may well overkill economic activity, especially when applied in a simplistic manner.
E. Structural Policy
In many cases, countries hit by crisis have varying degrees of structural weakness, and it is important to address this root problem. However, the Fund's involvement in structural issues should be limited to those impediments that directly affect government fiscal and monetary policy management. Other structural issues should be dealt with primarily by the World Bank and other relevant institutions as medium- to long-term challenges.
As for financial sector reform, only those measures that are deemed urgent and absolutely essential to resolving the current crisis should be included in Fund adjustment programs, based on full cooperation with the World Bank.
At times of crisis, the Fund should refrain from requiring too broad or ambitious structural reform, since the targets would very likely be missed amid the political confusion that often occurs during a crisis, and this could lead to an even further erosion of market confidence.
The Fund should recognize that market economies can have various forms, reflecting each country's history, culture, and stage of economic development.
F. Provision of Liquidity --- Enhancing theLender of Last Resort Function of the IMF
1. Establishing a New Facility
Looking back on recent experience, it is clear that modern-day crises stem not only from specific problems in particular economies but also from general problems inherent in the global economic system, namely risks involved in large and abrupt movements of short-term capital. To address such problems, in addition to the contingent credit line (CCL) currently under consideration by the Board, the establishment of a new Fund facility to enhance the lender of last resort (LOLR) function of the Fund may be appropriate.
The new facility would be used by countries with a good track record on macro-economic policies as well as on financial sector supervision, as certified through regular surveillance, for quick disbursements to those relatively well-managed economies affected by contagion. The modalities of the new facility would be as follows:
The facility would aim only at overcoming present difficulties; policy requirements would be limited to those serving this objective.
The general resources of the Fund, even after the eleventh quota increase and NAB, might not be sufficient for the Fund to play an enhanced role of LOLR. It is therefore conceivable to let the Fund borrow in the market, as the institution is granted the capacity to do so in its Articles. The borrowed funds would be used exclusively for the SRF, the CCL, and the above-mentioned new facility. This is logical, since such borrowing would be a means of recycling private funds which have stopped flowing into, or have indeed flowed out from, emerging economies.
2. New General Allocation of SDRs
The Fund could augment member countries' foreign reserves through a general allocation of SDRs. Considering the fact that there is a global need to supplement reserves, especially in emerging economies, and that the risk of inflation is historically low, the case for a new general allocation is very strong.
III Improving IMF Procedures
In order to improve the Fund's accountability and to further strengthen the involvement of its shareholders, the Fund's decision-making procedures need to be improved.
A. Establishing Program Committees
Program committees should be set up in the Executive Board to further enhance the involvement of the Board members in the formulation of Fund programs. Before missions are sent, these committees should discuss and agree on basic policies, which are central elements of the prospective programs for countries in need of the Fund support. The Committees should also monitor developments in the program negotiations.
One committee would be established in each of the six regional departments. Each Executive Director would belong to two committees, according to his/her interests. Representatives from the program country could be invited when appropriate.
B. Participation by Country Representatives
Representatives from the country in question should be invited to participate in Board discussions on surveillance or programs, in order that the Board members themselves can have a candid exchange of views with the authorities in charge of the surveillance or program negotiations. This is particularly important for countries which are represented at the Board by Directors or Alternates from other countries.
C. Further Transparency and Accountability
In order to maintain the high quality of the work done by the Fund, and to strengthen the accountability of the Fund through improved transparency, all staff papers should be published after a certain period, say six months after the Board meeting. Staff papers could also be made public immediately after a meeting if the member concerned so wishes. This general rule should apply to both surveillance and program papers.
All confidential documents exchanged between the Fund staff and the authorities at the program negotiations, such as side letters, should be presented to the Board along with other program documents in order to enhance the accountability of the staff. Even when confidentiality is necessary, such documents could be circulated to the Executive Directors and collected back during a closed session. Publication of such documents would also be possible after relatively longer lapses of time.
D. Evaluation Unit
An evaluation unit reporting directly to the Interim Committee should be created. This unit, with input from outside experts, would monitor the appropriateness and effectiveness of Fund policies and programs, send its reports to the Committee, and make them public.