Reforming the International Monetary and Financial System

Comments: Ideas on Reforming the International Financial System

Alexander Swoboda, and Peter Kenen
Published Date:
December 2000
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Yung Chul Park

At the outset I should make it clear that I belong to the “financial panic” camp. David Lipton does not seem to include himself in the IMF camp, although he gives the IMF high marks for its contribution to stabilizing international financial markets during the two years after the East Asian crisis.

Lipton argues that international financial markets should be able to and induced to prevent and manage futures crises themselves. To this end, Lipton wants the international community to come to an agreement for limiting member countries’ access to IMF credit facilities, including the SRF and CCL, so as to minimize the problem of moral hazard.

New limits on IMF lending should be supported by encouraging members to adopt flexible exchange rate systems and private sector workout programs. According to Lipton, the IMF should be restructured in a way that will enable it to deal primarily with any future systemic threats to the international financial system. For this purpose, he recommends the creation of a trust fund by pooling the SDRs of a select group of large countries, meaning the G-7.

In my comments, I will argue that (1) flexible exchange rate systems are not likely to work as well as Lipton thinks they will; (2) a trust fund is not needed; and (3) the international community must consider the idea of establishing regional monetary arrangements more seriously, and allow more active participation of emerging market economies (EMs) and developing countries (DCs) in developing international standards and arranging workouts.

In the two years after the crisis erupted in East Asia, numerous proposals have been put forward to reform the international financial system, by G-7 and G-22 governments, multilateral organizations, and private institutions. From the point of view of East Asian countries, many of these proposals do not stand a chance of being implemented, in part because they do not reflect the lessons of the East Asian crisis.

These proposals begin with the premise that structural weaknesses in the East Asian countries, together with short-run macroeconomic imbalances, were responsible for triggering and spreading the crisis through Asia and beyond. As such, these proposals focus on structural reforms in these countries: strengthening the prudential regulatory system for banks; improving accounting practices and disclosure requirements for increased transparency; creating accountable and transparent corporate governance; and promoting greater flexibility in the labor market.

In a recent paper, Stiglitz and Bhattacharya (1999) suggest that these structural weaknesses were not necessarily the causes of the crisis. As Feldstein (1998) points out, certainly structural reforms were not needed to gain access to international capital markets. This does not mean that the crisis countries in East Asia do not have to carry out structural reforms. Such reforms will make these countries less vulnerable to speculative attack, but the focus of reforming the international financial architecture should be the market failures that cause financial panic and herd behavior.

Short-term capital movements have been too volatile, and crises have been too contagious to be explained by the rational behavior of market participants. Although it is now well established that international lenders have as much responsibility for crises as borrowers, one seldom hears any serious discussion as to whether and how lenders to emerging markets should be supervised or regulated.

My comments below discuss some of the central elements of reforming the international system, including international standards, exchange rate systems, reserve holdings, and the role of the IMF.

Standards and Enforcement

Most proposals for a new international architecture advocate establishing a set of international standards and encouraging countries to adopt them. Many standards already exist: the Basel capital adequacy accord, International Accounting Standards Committee accounting standards, International Organization of Securities Commissions’ principles of securities regulation, and the Organization for Economic Cooperation and Development standards of corporate governance. The IMF has developed the Special Data Dissemination Standard and is preparing codes of fiscal practice and monetary and financial transparencies. Since it may not be feasible from a national sovereignty standpoint to establish and enforce strict global rules or create global authorities such as a world central bank and world regulatory authority, setting and enforcing international standards are recommended as a second-best solution.

Everyone agrees, though, that such standards are not a panacea. They are often too vague to mean much.1 Major industrial countries cannot agree on specific standards for banking, corporate governance, disclosure, and accounting, because they understandably insist on standards that will serve their interests. In most of the forums drawing up standards, emerging market economies and developing countries are not included or are, at best, underrepresented.

Even if G-7, emerging market, and other developing countries could come to an agreement on international accounting standards, as well as on banking and other regulatory issues, there still remains the question of enforcement. On this issue, some proposals suggest that cooperation and coordination between different supervisory organizations should be strengthened. Others argue that the IMF should be entrusted with the role of monitoring and supervising compliance of its member countries with standards. Still others recommend that enforcement should rely more on incentives to induce countries to observe standards voluntarily.

The IMF does not have either the personnel or the expertise to undertake a detailed international supervision of financial and other standards of emerging market economies. This means that the IMF will have to create an incentive structure that directly links the amount of money a member can borrow to its banking and other standards. Along with the IMF, it has also been suggested that financial regulators of advanced countries could also help enforce standards by controlling the access of EMs and DCs to international capital markets on the basis of their record of compliance.2 Many EMs and DCs will find it difficult to accept these incentive-based proposals, because such schemes raise issues of fairness and national sovereignty. If the incentive system is determined and administered by both the IMF and regulatory authorities of advanced countries, in reality this means that advanced countries can dictate the access of EMs and DCs to world capital markets and IMF credit facilities.

Incentives will necessarily differ among EMs and DCs, since these economies cannot be lumped into a single group. Differentiation, however, will make the incentive system highly susceptible to elements of arbitrariness, discrimination, and bias. One cannot even discount the possibility that advanced countries could use the incentive scheme to achieve other objectives.

The General Agreement on Tariffs and Trade member countries took seven years to negotiate an agreement on new rules for freer goods and services trade, and to create the World Trade Organization in the Uruguay Round (1986–93). Standards are not rules, but if the member countries of the IMF cannot agree on setting and enforcing standards, then a negotiation process like the Uruguay Round may be an alternative solution. This may be particularly necessary if the interests of advanced countries diverge from the interests of EMs and DCs.

The G-7 countries could take the initiative in starting a negotiation process among the IMF members to establish international standards. The negotiation may not take as many years as the Uruguay Round did, but it will have to go through an arduous and protracted process of settling differences between advanced countries and EMs and DCs. Such a negotiation process will be costly, but unless the IMF member countries come to an agreement on common standards, the compliance of firms, banks, and governments of EMs and DCs cannot be ensured. To reduce the number of participants and make the negotiation more manageable, participation in the initial stages could be limited to EMs and DCs with open trade and financial regimes. Without this process, there could emerge two sets of competing standards supported by the United States and European Union, respectively. Neither set of standards would in that case reflect the needs or wishes of EMs and DCs. They would then either adopt the standards of one or the other, or remain outside both.

EMs and DCs would accept, in principle, the argument that international financial markets should bear the cost of managing crises more than before by making it clear that all debt service of EMs and DCs to private creditors will not be paid. As Lipton points out, though, international financial architects have not been able to develop even a broad framework of workouts involving provisions for loan contracts and bank credits, or creating standing committees of creditors. For example, most financial architects agree that bond contracts should be restructured to include collective-action clauses based on majority vote, but it is clear that EMs cannot voluntarily change their new bond contracts because such a move is likely to raise the cost of borrowing. In this regard, advanced countries should set an example by first introducing collective-action clauses in their foreign bond contracts. The G-7 countries, however, have yet to agree on whether and how these clauses should be incorporated into bond contracts.

As in the case of setting international standards, EMs and DCs are not included in the discussion for workouts, although as debtors they will be affected by decisions on when workouts should be initiated and what their conditions should be. In this respect, I agree with Lipton that the debt restructuring and its terms, and the legal base for private sector participation, should be negotiated in international forums that include EMs and DCs.

Exchange Rate System and Reserve Holdings

In the aftermath of the crisis, East Asian countries, except for Malaysia, moved toward flexible exchange rate systems, with the expectation that greater flexibility would diffuse the impact of adjustment to exogenous shocks. Flexible exchange rates are also expected to give banks and corporations an incentive to hedge their foreign exposures and, in so doing, reduce the frequency of foreign exchange crises. It is perhaps too early to assess the effects of the flexible exchange rate system on East Asia’s recent recovery. The available evidence suggests that, contrary to expectations, the free-floating system has neither enabled East Asian countries to regain their monetary autonomy nor enabled them to reduce their holdings of reserves.

In a world of free capital mobility, the East Asian experience suggests that the adjustment process of a flexible exchange rate system could easily generate a cycle of boom and bust, accentuated in export-oriented economies. For instance, consider a large increase in capital inflows to an EM, attracted by an exogenous increase in productivity. The inflow initially creates pressure for currency appreciation. Without central bank intervention, the inflow will be expansionary, and prices of assets including real property start moving up. Because of this asset market development, the initial appreciation of the nominal exchange rate, even when it overshoots, does not necessarily generate any expectation of depreciation in the short run and, hence, results in further inflows. The increase in capital inflows will eventually lead to deterioration in the current account. Depending on the nature of the shock, it may take anywhere from six to nine months to observe the effect of the increase in capital inflows on exports and imports. Only when the current account begins to show signs of deterioration would an expectation of currency depreciation set in. Once they see an incipient current account deficit, foreign portfolio investors and lenders often respond by pulling out their investments all at once, thereby precipitating a crisis.

The reason for the herd behavior of market participants is not clear, but East Asian experiences show that it is related to the market’s inability to process and assess the information available for making investment decisions. At present, foreign investors are flooded with numerous reports and analyses on short-run macroeconomic forecasts and on the current state of financial institutions and corporations published by public as well as private institutions.

The problem is not the lack of information but rather the inability of foreign investors to process the large amount of information available. In this state of confusion, there always emerges a group of investors that exercise decisive influence on the assessment of available information. Sometimes they are credit-rating agencies or analysts working for major investment banks or other institutional investors. Once they agree that the balance of payment problems will worsen, then other smaller and less-informed investors follow the actions of these lenders.

Capital markets of EMs are relatively small in terms of their market valuation. In many East Asian countries, in fact, foreign portfolio investors have become dominant forces in determining the direction of asset price movements, since these countries began opening their capital markets in the early 1990s. The ongoing recovery in East Asia has been attracting large capital inflows to the region, much more than the East Asian countries can absorb in the short run. These large inflows could rekindle a real asset boom and speculation.

As noted in the previous section, East Asian policymakers are under constant pressure to maintain stable nominal as well as real exchange rates. Therefore, the monetary authorities in these countries may attempt to sterilize some of the capital inflows as they have before, but the sterilization will not improve the situation, because it increases either the money supply or interest rates (when combined with open market sale of securities). Although they realize that they are fighting a losing battle, the monetary authorities continue to use monetary policy as the main tool to stabilize the nominal exchange rate. As a result, these countries do not enjoy any degree of monetary autonomy, although they are on a flexible exchange rate system.

The preceding argument does not necessarily mean that EMs should eschew a flexible exchange rate system in favor of other arrangements with less flexibility. For example, most EMs would not find it practical or politically acceptable to move to a currency board. Other arrangements such as crawling pegs with wider bands have their share of problems, and the continuing debate on the issue is not likely to produce a consensus on an optimal exchange rate system for EMs and DCs.

If EMs are going to stay with flexible exchange rate systems, they must consider introducing a system of control over short-run capital movements to ease the burden of adjustment through exchange rate fluctuations. In this respect, the IMF, while advocating an overall liberalization of capital account transactions, points to the need to implement measures to influence the volume and characteristics of capital flows. Such measures could include taxes on short-term foreign borrowing and prudential limits on offshore borrowing.

The Chilean experience with short-term capital controls has been widely accepted as a successful case. During the 1990s, Chile imposed a 30 percent reserve requirement on all capital inflows with no interest, and also required foreign direct investment to stay in the country for at least one year. It is generally agreed that the Chilean policy was successful in lengthening the average maturity of the country’s foreign currency debt.

In a recent article, however, Edwards (1998) disputes Chile’s successful management of capital inflows. He shows that the capital control measures did not sufficiently reduce the share of short-term to total debt, did not succeed in slowing the appreciation of Chile’s currency, and did not appreciably increase central bank control over monetary policy. Chile’s capital controls also raised the cost of borrowing. As expected, large firms were able to find ways to circumvent the controls. Edwards has recently placed more emphasis on prudential supervision and regulation of financial institutions for the control of short-run capital movements.

There is another potential dilemma with the Chilean type of control: the adverse selection problem. Some foreign investors, including commercial and investment banks, are not focused exclusively on speculation for short-term profits. Indeed, many international lenders often move into emerging markets in search of long-term investment opportunities and establish long-term relationships with local financial institutions. Yet a uniform reserve requirement on all capital inflows penalizes not only short-term speculators but also those investors who will help strengthen and stabilize EMs’ links with the international financial community. If the tax rate is very high, these desirable investors will avoid the EMs with capital controls. Their withdrawal will in the end lower the quality of international investors, more so when foreign investors move together in a herd. A lot more work will therefore have to be done on the modality of capital controls before rushing to construct a control apparatus.

Many EMs, in particular those that have experienced a financial crisis, are taking measures to build up their foreign currency reserves above the level that has been regarded as adequate in terms of their import requirements. For instance, Korea is currently targeting a level of reserves equivalent to 20 percent of its GDP, largely because of an increased volume of capital account transactions. By any measure, this level is excessive and costly and represents a clear case of resource misallocation. To reduce the amount of reserve holdings, at least some of the EMs could enter into an arrangement for precautionary lines of credit with private financial institutions. They could also rely on the IMF as lender of last resort, which could provide an additional issuance of SDRs.

There are other schemes for reducing the holdings of foreign currency reserves. For instance, the IMF could take the initiative in organizing cooperative arrangements among central banks to enlarge swap arrangements, both within regions as well as between G-10 and other countries.3 The enlargement as well as effectiveness of swap arrangements between the G-10 and EMs will be limited, however. The central banks of the G-10 countries will not have strong incentives to enter into the swap arrangements with the EM, because the swaps are, in effect, equivalent to direct lending to the EMs.

Another possible scheme would be to entrust the IMF with the role of managing the reserves of its members. For example, a group of countries, not necessarily from the same region, may decide to pool a certain percentage of their reserves to create new credit facilities for themselves. An individual country belonging to the arrangement would not have to hold as much in reserves as it would otherwise if it could borrow from the credit facility when it experiences a reserve shortage. As a crisis manager and lender, for instance, the IMF could manage such a facility, setting the maximum amount and the conditions under which the participating countries could draw from the facility. Depending on the demand for such credit lines, the IMF could manage similar facilities for many groups of countries.

The IMF as a Crisis Manager-Lender and Trust Fund

In a recent paper, Stanley Fischer argues that the IMF can act as crisis lender or as crisis manager, although it does not have the power to create international reserves.4 As crisis lender it has access to a pool of resources contributed by its collective members, which it can lend to individual member countries. Because it has the responsibility of negotiating with member countries in a crisis and arranging financial packages, it serves as crisis manager.

One might question whether the IMF will have enough resources at its disposal to serve as an effective crisis lender, but let us assume it could and would. Then, looking into the future, the IMF will be lending mostly to EMs and DCs in a crisis, and will serve as their crisis manager. In this scenario, the IMF would seldom lend to the G-7 countries even when they were in a crisis.

Lipton’s proposal for the creation of a trust fund will serve to reduce the role of the IMF as a crisis manager-lender for EMs and DCs. On paper the IMF will continue to play the role of an international lender of last resort, but that role will be taken over by a group of large countries that would directly administer the trust fund to combat systemic threats to the international financial system. For the purpose of constructive ambiguity, Lipton wants ex ante country eligibility, financing amounts, and the role of conditionality to be unknown. This constructive ambiguity may be interpreted as lack of transparency, however, and could become a source of confusion and arbitrary decisions.

Suppose a financial crisis breaks out in an EM. The trust fund will not be activated unless the crisis is believed to be a threat to the stability of the international financial system. However, the crisis is likely to be contagious and spread to other countries and regions. At what point, then, should the trust fund be activated? One might ask why the G-7 countries should have the authority to make that decision and assume the role of international lender of the last resort. If it is going to be established, perhaps the trust fund should be complemented by regional monetary arrangements.

The structure of the IMF is similar to that of a credit union. However, unlike a typical credit union, there is a clear demarcation between net depositors (lenders) and net borrowers. Advanced countries constitute the majority of lenders, whereas EMs and DCs make up practically all of the IMF’s borrowers. Rich industrial countries control the decision-making process as well as operations of the IMF. Given this dominance, one could legitimately raise the concern that the IMF may be “too responsive to its principal shareholders, which are high-income, international creditor countries whose interests do not necessarily coincide with those of the global society as a whole.”5

One might go one step further by saying that the IMF is constrained in reflecting the needs and wishes of EMs and DCs. Even though international creditor countries themselves are as much responsible for the East Asian crisis as East Asian countries are, the IMF has been preoccupied with structural reforms of EMs and DCs, while ignoring the problems on the supply side of capital flows.

In order to redress the imbalance between advanced countries and EMs in managing the IMF, EMs and DCs should be given the opportunity and be prepared to contribute more resources for the operation of the IMF. Commensurate with their enlarged contribution, EMs and DCs should be accorded greater representation both on the Executive Board of Directors and in management. Many EMs are more willing and able to share the burden of financing various IMF credit facilities than ever before. This issue of representation will become more contentious in the future, if the IMF is given a central role in surveillance and the enforcement of various standards.

The IMF is an international institution that provides the public good of international financial stability. Crisis management and prevention does have externalities, and is the responsibility not only of EMs and DCs, but also of advanced countries. Nevertheless, it is only natural and logical for EMs and DCs to have a greater voice in managing the organization that is primarily serving as their crisis lender-manager.

Advanced countries will likely object to the idea of giving EMs and DCs a large representation in running the IMF. They may argue that without the dominant participation of advanced countries, the IMF may suffer from leadership problems, deterioration of the quality of staff output, and laxity in the enforcement of standards and loan conditions. The same types of criticisms have been leveled against those who support the establishment of regional monetary funds.

If the decision-making process at the IMF is not politically neutral, and for this reason EMs and DCs cannot expect more active participation in the IMF decision-making process, then the G-7 and the IMF should consider amending the IMF Articles of Agreement to strengthen the independence of the Executive Board and give the IMF financial independence.6 Failing this, the G-7 and the IMF should be more positively disposed to the idea of creating regional monetary arrangements. Indeed, if one can argue that regional economic arrangements could serve as building blocks rather than stumbling blocks, then the same argument can be made for establishing regional monetary arrangements.

Regional arrangements could be structured in a way that could complement, not substitute for, the role of the IMF. The Uruguay Round established the World Trade Organization with much enhanced enforcement powers, and gave birth to a large number of regional economic arrangements. In fact, more than 90 percent of all the contracting parties in the General Agreement on Tariffs and Trade are signatories to such arrangements.

In the discussion about reforming the IMF, a consensus has emerged that the organization cannot be the sole locus of future financial liberalization and the stabilizer of international financial markets. Regional arrangements could be presented as a complement to IMF efforts to liberalize capital account transactions, provided, of course, that such arrangements are subject to outside discipline and do not become preoccupied with regional issues and initiatives.

Both multilateral and regional approaches can be effective and efficient in maintaining international financial stability. This is because financial crises tend to be regional mainly because trade is regional.7 With a large increase in intraregional trade in recent years, financial crises are more likely to spread through trade linkages than before.

Along with the expansion of intraregional trade, there has also been a large increase in intraregional capital movements. This development also calls for closer policy coordination among the countries in various regions to regulate and supervise regional financial institutions.


    De GregorioJosé and others1999“An Independent and Accountable IMF,”Geneva Report on the World EconomyVol. 1 (April) pp. 13134.

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    EdwardsSebastian1998“Capital Flows, Real Exchange Rates, and Capital Controls: Some Latin American Experiences,”paper presented at the National Bureau of Economic Research Conference on “Capital Flows to Emerging Markets”Cambridge, MassachusettsFebruary.

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    FeldsteinMartin1998“Refocusing the IMF,”Foreign AffairsVol. 77 (March-April) pp. 2033.

    FischerStanley1999“On the Need for an International Lender of Last Resort,”Journal of Economic PerspectivesVol. 13 (Fall) pp. 85104.

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    Griffith-JonesS. and JennyKimmis1999“Capital Flows: How to Curb Their Volatility,”paper prepared for UNDP as background for the 1999 Human Development Report.

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    RoseAndrew1998“Limiting Currency Crises and Contagion: Is There a Case for an Asian Monetary Fund?”unpublished; University of California atBerkeley.

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    StiglitzJoseph and AmarBhattacharya1999“Underpinnings for a Stable and Equitable Global Financial System: From Old Debates to a New Paradigm,”paper prepared for the Eleventh Annual Bank Conference on Development EconomicsWashingtonApril28–30.

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1See The Economist, January 30-February 5, 1999.
2For a general discussion of these issues, see again The Economist, January 30-February 5, 1999.

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