Reforming the International Monetary and Financial System

Comments: Some Lessons from the Russian Crisis

Alexander Swoboda, and Peter Kenen
Published Date:
December 2000
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Tatiana Paramonova

I would like to focus on those aspects of the problem under discussion that are tied directly to the lessons of the Russian crisis, because in many cases they provide a graphic illustration of some of the points David Lipton makes in his paper.

Lessons of the Russian Crisis

The first lesson concerns the exchange rate mechanism and opportunities to use it for the purposes of macroeconomic stabilization. The experience of both Russia and a number of other countries shows that attempts to use an exchange rate peg as a key instrument of anti-inflationary policy are doomed to fail if they are not backed up by serious transformations in other areas (particularly the fiscal and structural realms). In an environment of insufficiently strict supervision of commercial banks, and a weak banking system as a whole, the fixed exchange rate mechanism in Russia was viewed as an implicit exchange rate guarantee and (in an environment of high domestic interest rates) contributed, one could say, to irresponsible and chaotic borrowing in hard currency.

Another source of policy failure was the way the government securities market was organized according to the financial pyramid principle, which was based on attracting expensive and short-term money in the hope of maintaining continuous refinancing. Not only did this policy not promote the implementation of fiscal and structural reforms, but it even slowed them down, because “easy” borrowed money made it possible to put off “difficult” and unpopular transformations.

The third lesson is for careful preparation and rational implementation of the liberalization of capital transactions. These preconditions were not implemented in Russia, and the huge inflows of foreign short-term capital into the government securities market resulted in sharply increased vulnerability for the economic system. It was not just Russian borrowers who were short-sighted, but also the foreign creditors, who were prepared to lend huge sums of money against quite dubious projects and guarantees. The most vivid example of moral hazard occurred in Russia, with private investors confident that there was little likelihood of default because they were counting on money from official creditors and international financial institutions, among other things.

A combination of all the above factors contributed to an “explosive mix” in the Russian economy, which was then ignited partly by the Asian crisis and the drop in world oil prices, and contributed to the exceptionally devastating crisis in August 1998.

Of course, it is much easier to analyze crises that have already occurred than it is to predict and try to prevent potential crises. Nevertheless, it is obvious that the policy pursued by the Russian monetary authorities, first to keep interest rates low and then to support the previously declared exchange rate, started heading in the wrong direction some time around October 1997. The hopes that the Russian monetary authorities had in the curative powers of the large-scale official aid package announced in July 1998 were not entirely justified either, given the scale of imbalances that had built up in the economy.

Another lesson learned was that decisions regarding a default on internal debt, a sharp devaluation of the ruble, and a moratorium on payments on foreign debts were all taken in the absence of any generally recognized rules of behavior in crisis situations. Thus, Russia earned, I would say, the “honor of being a trailblazer in a minefield” and setting a precedent for large-scale default. This again emphasizes the urgent need to redesign the architecture of the international financial system as a whole.

Conclusions for the Future Financial Architecture

I would like to share with you certain conclusions that I have drawn since the August 1998 Russian crisis and from the stabilization measures that have been taken in the meantime.

First of all, there is probably not just one optimal exchange rate mechanism that would be universally suited for all countries at all stages of development. An exchange rate peg is possible in combination with other effective economic policy measures. At the same time, it is preferable to move away from a fixed-rate mechanism when normal economic conditions prevail. Defending a fixed rate requires considerable outlays from central bank reserves. Abandoning an exchange rate peg when a currency is being attacked is fraught with the danger of a sharp decline in the exchange rate and a collapse of the financial system.

My second conclusion is that in an environment of increasingly globalized capital flows, the successful implementation of exchange rate policy in emerging market countries is becoming an indicator of a responsible resolution of domestic economic and financial problems. As the recent experience of Russia and a number of other countries shows, defending the exchange rate at the expense of foreign exchange reserves is doomed to failure from the outset when there are serious economic imbalances. This principle may extend, to a lesser degree, to the crawling peg system as well. The conclusion is frequently drawn that in the current environment, emerging market countries have to choose between a system that allows for a relatively free-floating currency and a currency board arrangement, which for all practical purposes means replacing the national currency with a foreign currency. It seems to me that this conclusion is somewhat simplistic.

Indeed, countries with currency board arrangements have successfully turned away attacks on their national currencies during the recent financial crisis. As a rule, however, they paid for this with a substantial slowdown in the rate of economic growth or even recession. On the other hand, some countries successfully withstood pressure on their national currency without making formal use of a currency board. These countries are characterized, first of all, by a healthy macroeconomic situation and a stable financial system, and second, by a significant level of reserves, which exceed their base money by a large factor given the current exchange rate. It seems that it is precisely these factors that determine the relative stability of a currency, regardless of the exchange rate system that is nominally in use, since they provide a great deal of freedom to monetary authorities and room to maneuver in times of crisis.

My final conclusion is that it would make sense to focus the IMF’s efforts on the development of measures aimed at both preventing crises and overcoming crises that have already occurred. In this connection I support the idea of Lipton’s concerning the development of a standard framework for crisis resolution even if it remains quite general. Indeed, there is an obvious need for generally recognized mechanisms to overcome crisis situations. So far, the only work in this area has been directed at involving private investors to help resolve crises. At the same time, in analogy to the research already done by the IMF on an “exit strategy” from an exchange rate peg mechanism, one could propose an “exit” strategy from poorly organized and prematurely implemented liberalization of capital transactions. In other words, internationally recognized procedures for approaching restructuring, default, and bankruptcy issues are needed. Their elaboration would allow crisis management to become better organized and create the prerequisites for more effective and predictable procedures for bailing in the private sector to help in crisis resolution. It would also be useful to focus on developing leading indicators of the investment climate, as well as on issues of transparency in transition economies.

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