The executive directors of the international monetary fund will be meeting this month to discuss a proposal to extend the IMF‘s articles of agreement so that it can pursue capital account liberalisation in member countries. In the light of the on-going financial crisis in South East Asia and the traumur this has brought to many people’s lives in the region it was anticipated that the executive directors would move ahead more slowly in their discussions in order to have time to examine the full facts of the cisis and assimilate its lessons into global and domestic financial mechansims. However, rather than taking a more cautious approach the powerful G7 governments, who between them control 47% of the votes in the IMF Board, want to press ahead with changing the IMF‘s articles as quickly as possible. This view is clearly expressed by Lawrence Summers,
“the right response to these experiences is much less to slow the pace of capital account liberalisation than to accelerate the pace of creating an environment in which capital will flow to its highest return. The pace of opening up should be matched by the pace of developing a sound domestic financial system. But both fast is better than both slow.”
FT, Go with the flow,11/3/98.
Yet there are many outstanding questions which neither the IMF nor the G7 governments have addressed, for example, how to limit the scale of a crisis and prevent contagion within and outside a region, how to limit moral hazard, and what sort of debt work out mechanism is needed. Whilst the IMF management may argue that these will be addressed in time the potential for global harm is too enormous to proceed with liberalisation before answers have been found for these problems.
What Is The IMF‘S Current Legal Status?
- At present the IMF does not have a legal basis for responding to crises arising in the capital account. Its articles of agreement did not address this issue because at the time they were drawn up there was a system of fixed exchange rates and it was not anticipated that financial crises of the type experienced in East Asia would arise.
- The articles also presume that governments will impose and maintain capital controls, and the IMF has no legal basis on which to persuade member countries to lessen their controls.
What Does The IMF Want To Do?
- Michel Camdessus, Managing Director of the IMF, has been advocating that the IMF‘s articles of agreements should be expanded to give it the legal basis from which to pursue capital account liberalisation. This would allow the IMF to make liberalisation or efforts towards liberalisation a condition for receiving its balance of payments assistance.
- The interim committee has stressed that the IMF should adopt an approach to CAL that is “bold in its vision, but cautious in implementation”, ie., CAL should be introduced in an orderly manner and should not proceed until the necessarily regulatory and institutional structures have been put in place, including a solid multilateral system for surveillance and financial support.
Statement of the Intermim Committee on the Liberalization of Capital Movements Under and Amdenment of the Articles.
What Other Measure Are Being Discussed?
The G7 governments are also proposing a number of other reforms which are intended to reduce the likelihood of crisis arising, these include:
- measures to promote more efficient functioning of global markets, including improving supervision and regulation of financial markets;
- strengthening financial institutions;
- better and more timely disclosure of national statistics and greater transparency in policy making;
- the IMF is being urged to strengthen its data dissemination standards;
- an improved communication mechansim for the IMF to allow it to voice concerns and force changes in policy in a more public way.
Does The Problem Lies With Individual Countries?
The G7, with the exception of Japan, and the IMF‘s senior managemnt appear to have taken the view that the crisis is “home grown” and has arisen largely because of economic mismanagement in the asian economies. Indeed, prudent behaviour by governments, for example, avoiding large and sustained current account deficits, keeping sufficient foreign exchange reserves, unpegging exchange rates when necessary, monitoring banks’ borrowings from abroad obviously should be encouraged but if the problem is more fundamental than this it wont be sufficient. Indeed, given the excellent performances in these economies until last summer, with much praise lavished by the IMF itself, then the massive fall in the South East Asian currencies cannot be regarded as an efficient market response and so the problem can not be regarded simply as a problem of the borrower.
It Takes Two To Tango
While there were obvious weaknesses in the Sout East Asian economies they have been reinforced and exploited by investors. The G7 and IMF have relatively little to say about the role of the investors, although they are pressing for increased transparency to try to address the problem of imperfect information which they blame for the poor lending decisions of investors. However, it is unlikely that this will be sufficient to change the behaviour of investors, even if greater transparency, including transparency on the part of the IMF, is welcome. Indeed, improving transparency is not likely to encourage less-irrational investor behaviour unless they are given stronger incentives to change their expectations. With or without good information, investors tend to react too slowly and when they do they either over or under react. The issue that most pressingly needs to be addressed is the issue of moral hazard. Informing investors that their investments are becoming more risky is not going to discourage many if the general trend is to stay in the market, especially if they assume they will be bailed out if the worst comes to the worst. Only if investors fear that they will feel the full cost of their imprudent investment decisions will they operate more efficiently.
Financial Markets Do Not Operate Efficiently
CAL increases the vulnerability of a country to swings in market sentiment. If the market was actually able to allocate resources efficiently it could be argued that this is not a problem, however, it is clear that markets react very inefficiently:
- Stanley Fischer remarks that currency crises start as rational reactions to policy mistakes or external shocks but as he himself points out, “the problem is that once started, they may sometimes go too far”, the failure of the IMF‘s bail-out packages to halt the currency decline in South Korea, Thailand and Indonesia demonstrates that neither is the IMF able to control how deep a crisis might reach;
- while there were obvious structural problems in the South East Asian economies hit by the crisis these were not fundamental problems and a gradual adjustment would have been more efficient than the massive withdrawal of finance that occured;
- the rupiah lost over 75% of its value as capital flowed out of the country, whilst there was a need for the rupiah to be devalued a fall of 75% can not be regarded as efficient;
- the are large problems of imperfect information in the capital markets and this is being heightened by the fact that there are now more financial actors but information is becoming more diffuse, therefore efficient behaviour becomes increasingly difficult ie. greater uncertainty leads investors to react in even more of a herd-like manner;
- markets react too late, for example, the ratings agencies did not downgrade risk ratings for the South East Asian economies until after the crisis had fully broken. This market imperfection is reinforced by the quick and largescale reaction of the markets once a problem has emerged;
- investors not only react too slowly once they do react they tend to over-react and withdraw from other economies too. This is what is known as the contagion effect and often, while in some cases this is a reaction to the change in relative exchange rates that must take place it need not be. The problem is that the IMF does not have mechanisms to address the contagion problem nor does it know what causes this effect, “contagion effects seem to be overreactions, perhaps based on incomplete information, perhaps a result of herd behaviour, perhaps based on an inaccurate appraisal of the underlying economic situation.Contagion effects are all the more worrying in the light of the possibility that attacks become self-fulfilling prophecies, for instance because the banking system weakens in the face of an attact that forces a devaluation and higher interest rates,” Stanley Fischer.
Problems With Short Term Capital Flows
The Japanese however do not view the crisis as an asian problem caused by economic flaws, rather they view the problem as a global one. To address this problem the Japanese government is calling for stricter monitoring of international capital flows through a global institution – probably the IMF.
Whilst monitoring is important others are arguing for stronger action to be taken on short-term flows. Indeed, as was seen in South Korea, the pressure to find productive use for capital inflows has led to more and more investments in less productive assets. There indeed seems to be a point at which an economy can become saturated with short-term investment. Thus it seems to be important to have some means of controlling capital flows. There is a case for controls both at the national and the international level. At the national level a country should be able to limit the influx of short-term capital as Chile does at the moment. At the international level, a Tobin-type tax could be useful for signalling to investors that speculative flows should be discouraged. Moreover, much of the interest in South East Asia over recent years can be seen as a reaction to poor investment opportunities in Europe and Japan and generally low interest rates in the industrialised countries, a Tobin Tax may discourage investment which simply seeks a quick buck and is quick to return once the picture brightens at home.
The IMF‘S Role Is Unclear
- Contrary to the assumption made by many, the IMF does not have a clear role to play in dealing with global financial crises. Whilst it provided very large bail-out packages to South Korea, Thailand and Indonesia it did not operate as a lender of last resort. Rather than disbursing funds quickly they were made conditional on governments restructuring their economies. Moreover, the many of conditions included in the IMF‘s programmes appeared to have little bearance on reforms necessary to ameliorate future crisis, either they were inappropriate for dealing with what is a private sector debt crisis or they were intended to further US and Japanese foreign policy, by for example, removing restrictions on certain imports.
- Neither should the bail-out resources have been used to pay off loans to private creditors. While there is a need to act to deal with the debt problems, an orderly debt work-out mechanism would be more appropriate and would give more appropriate signals to investors. In the case of South Korea and Thailand it was the US and Japanese governments which pushed for and eventually achieved a debt rescheduling strategy, yet this is one function that the IMF might have usefully performed, although even this is doubtful given its appalling record in addessing the debt reduction needs of African countries.
The IMF‘s articles of agreement should remain unchanged.
At a minimum mechanisms to monitor short-term financial flows need to be established and preferably mechanisms to control these flows should be implemented in both recipient and source countries.
There has been a thorough review of the global financial system and an external evaluation of the IMF‘s response to the crisis.