Chapter 39 Less Is More in the New International Financial Architecture
- International Monetary Fund
- Published Date:
- January 2001
Reforming the “international financial architecture” is one of the most important and pressing questions facing international policy-makers today. A sturdy structure will help to minimize the risk of collapse, but much disagreement exists about how best to lay a firm foundation. Eichengreen and Litan have provided impressive and extensive overviews of possible reforms of both the international capital markets and the IMF to achieve this goal. Their papers focus on international rescues operations, also known in less polite company as “bailouts.” Both make a convincing case that the IMF cannot take on the deus ex machina role of an international lender of last resort, and I wholeheartedly concur.
Rather than try to summarize their wide-ranging and thoughtful proposals, I will elaborate a theme that emerges from their papers and that can be applied to three aspects of the new international financial architecture: less is more. I borrow this phrase from one of the greatest and most influential architects of the twentieth century Meis van der Rohe, whose steel and glass structures loom large on the skylines of cities such as Chicago. Less reliance on politicized domestic banking systems, less bailout capacity, and less inflexibility by creditors in debt renegotiation can lead to more stability and to a firmer foundation on which international financial markets and institutions can operate.
1. LESS RELIANCE ON POLITICIZED DOMESTIC BANKING SYSTEMS CAN REDUCE LIKELIHOOD AND SEVERITY OF CRISES
Banking tends to be a sector, which faces large political pressures. Since banks tend to be highly regulated and to have their fortunes tied directly to the operation of the central bank, politicians have the potential to exercise considerable control over banks and the allocation of credit. In many countries, the commercial banks are little more than off-balance-sheet fiscal arms of the government. Politicians may use banks to provide subsidized credit to various sectors, as a form of industrial policy, and to targeted groups to increase political support. In return, banks often receive protection from competition through regulation and subsidies from the central bank.
Since the government is so heavily involved in banking, it may be very difficult to have effective government regulation of the domestic banking and financial sector. In these circumstances, simply hiring more and better-trained supervisors and adopting good regulatory principles is not sufficient because the government may have little incentive to enforce rules of sound banking, either on state-owned banks or privately-owned banks. The co-dependence of the banks on the government and of the politicians on the banking industry allows problems to grow unchecked, as the depth of the banking troubles in the Asian currency crisis countries illustrates. These perverse incentives are not unique to developing countries, as the long delays in responding to the Savings and Loan crisis in the U.S. and the banking problems in Japan also show.
The collapses of the domestic banking systems have contributed to the severity of the economic crises (and perhaps were an initial cause) and have slowed recoveries. A key reform would be to open the domestic banking markets to foreign competition. An increase in foreign bank penetration in emerging markets can generate a virtuous circle in that foreign banks tend to be less politically connected and less likely to be able to “capture” and be captured by the regulatory authorities (Kroszner, 1998a). Foreign institutions are less likely to succumb to pressure for directed lending by the government. With capture less likely and fewer direct benefits to the politicians of bank regulation (e.g., through quid pro quos for directed lending), regulatory reform becomes more likely. In addition, given their weak current state, the local banks are less likely to be able to oppose greater openness (Kroszner and Strahan, 1998).
Foreign financial institutions provide an extremely valuable stabilizing force that will help emerging markets to recover more quickly following a negative shock and generally promote stable economic growth. The domestic banks in these countries tend to be very poorly diversified, with most of their assets tied to the local economy. The collapse of the domestic banking system can make it difficult for local businesspeople to raise funds for positive net present value projects, thereby slowing recovery. Foreign banks, however, are internationally diversified and can ease such credit squeezes. Breaking down international barriers to bank entry is analogous to the recent elimination of barriers to interstate bank competition in the U.S. Allowing entry by banks from other states has been shown to increase state economic growth (see Jayrantne and Strahan, 1996). Less reliance on politicized local banking systems thus can produce more stability and growth. Less is more.
2. LESS BAILOUT CAPACITY CAN PRODUCE MORE STABILITY
As Eichengreen and Litan note, the IMF cannot act as an international lender of last resort as it is now constituted. Unlike domestic central banks, the IMF does not have the ability to create dollars, euros, pesos, etc. and thereby lacks a key feature of credible and effective last resort lenders. Although few countries are likely to be willing to cede their monetary sovereignty to the IMF to permit it to have such powers, the question remains of whether the IMF should be restructured to take on this function. I believe that the members of this panel would agree that, regardless of political feasibility, it is not desirable for the IMF to take on this role.
Perhaps the most important problem is that of moral hazard. As is well understood, and has been illustrated in numerous domestic banking crises such as the U.S. Saving and Loan debacle, the potential for ex post bailouts undermines ex ante market discipline (e.g., Kroszner and Strahan, 1996 and Kaufman and Kroszner, 1997). If there is an expectation of implicit insurance from the IMF, foreign investors will not exercise sufficient care in determining whether a country’s debt is sound before investing. The mere existence of the moral hazard problem, however, does not mean that all forms of last resort lending are undesirable and that markets will inevitably lose their disciplinary role in a blind-faith reliance on bailouts. All forms of insurance involve some degree of moral hazard but that does not imply the existence of insurance companies is destabilizing or contrary to market discipline.
The extent of the moral hazard problem thus is the important issue, but its magnitude is an empirical question that is extremely difficult answer, particularly ex ante. As Litan notes, many market participants characterized the purchase of Russian debt in the spring and summer of 1998 as a “moral hazard play” because Russia was considered too important (some would say too nuclear) to fail. The ability of Russia to continue to raise funds internationally in the late summer was in large part due to the expectation that the IMF (and major Western governments) would provide some protection for investors. The IMF, however, did not. Russia defaulted on its debt, the ruble collapsed, and many of the world’s most sophisticated investors lost billions.
The silver lining in the dark cloud of the Russian currency and financial crisis is the lesson that the IMF cannot be relied upon to bailout investors even in strategically important countries such as Russia. Perhaps the Russian crisis can be seen as the cost of the rescue package for Mexico in the mid-1990s, that is, the price that had to be paid in order to unlearn the apparent lesson from the Mexican bailout that international investors would be protected. The IMF did not have the resources to generate a credible rescue package for Russia and other governments were not willing to provide further funding at that time.
The constraint on the financial capacity of the IMF, thus, provides the benefit of mitigating the moral hazard problem. Additional funding for the IMF without steps to reign in the potential for moral hazard, however, relaxes the constraint and diminishes this benefit. Increasing the financial capacity of the IMF and moving the IMF in the direction of an implicit international lender of last resort may undo the hard-learned lessons of the Russian crisis. A less potent and less generously funded IMF could provide more stability in the international markets. Less is more.
3. CREDITORS WHO DEMAND LESS MAY RECEIVE MORE
The difficulties of debt renegotiation after a country falls into distress and the lack of clear and enforceable bankruptcy rules for international debt are identified by both authors as important targets for reform. Eichengreen details a number of specific changes to international debt contracts to reduce ex post coordination and bargaining costs and draws on historical experiences to consider the formation of active creditor committees to streamline the work-out process. Others, such as Sachs (1989) and Krugman (1998), have emphasized the distorted incentives that can occur when a country suddenly is overburdened with debt, because the debt overhang can act as tax on potential new investment projects. There may exist a debt “Laffer Curve” in which partial debt forgiveness can improve the welfare of the country by reducing the overhang and simultaneously leading to a better ultimate pay-off to bondholders.
While there has been much discussion of debt relief, almost no empirical work exists to determine whether countries ever are on the “wrong side” of the debt Laffer Curve. The extent of devaluations and debt overhangs in Asia and Russia have few precedents, but an instructive parallel can be drawn with the experiences of countries abandoning the gold standard during the Great Depression. The U.S. dollar, for example, declined sharply and suddenly against the French Franc and British Sterling soon after Roosevelt took office, and the gold content of the dollar was then officially devalued by sixty-nine percent with respect to the old gold parity. (Keynes characterized this period of high volatility of the U.S. dollar as a “gold standard on booze.”) Since mid-1997, the devaluation of the Asian and Russian currencies with respect to the dollar has been between forty and eighty percent.
Until the Great Depression, most long-term debt contracts in the U.S. (both public and private) included a gold indexation clause, allowing creditors to demand repayment in dollars valued at the old exchange rate. If this clause had been enforced, debt payments thus would have increased by sixty-nine percent. Since there was roughly $100 billion of gold-clause debt outstanding and GDP was roughly $60 billion, enforcement of the gold clause would have increased the debt burden by more than GDP. Similarly, when the Asian currencies fell in value, the burden of their dollar-denominated debt rose. Following the devaluations, the external debt to GDP ratios increased sharply to exceed one in some cases.
Rather than allow many firms to be pushed into bankruptcy, in 1933 the U.S. government declared that it would not permit these clauses to be enforced, which was upheld in a landmark five-four Supreme Court decision. An examination of assets prices responses to the announcement of this debt relief shows that not only corporate equity but also corporate debt rises in value (see Kroszner, 1998b, for details). The equity and debt of low-rated and heavily-indebted firms experience the greatest increase, so firms closest to bankruptcy benefited the most from the decision. Government bonds with the gold clause, however, fall in value. These results suggest that the expected costs of financial distress and distorted incentives due to debt overhang were sufficiently high that the country was on the wrong side of the “debt Laffer curve.”
In such circumstances, it may indeed be better to forgive than to receive. Asking for less can result in receiving more while also making the distressed country better off. While we cannot conclude from this historical episode that debt forgiveness today would improve the welfare of holders the currency crisis countries’ debt, the parallels suggest that this is plausible possibility. New provisions in international debt contracts and new structures to coordinate debt renegotiation and relief thus are worthy of further investigation. Once again, less can be more.
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