Financial Risks, Stability, and Globalization

9 Safety-First Monetary and Financial Policies for Emerging Economies

Omotunde Johnson
Published Date:
April 2002
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Recent crises have highlighted the need for countries to adopt safety-first strategies rather than adopting strategies that might maximize short-term growth. In this paper, I consider three central policy areas: exchange rate regimes, liquidity policies, and banking sector policies, in an attempt to give a better picture of safety-first strategies. These are, in themselves, three very broad areas and, consequently, the treatment is highly selective. Moreover, in each area there is already a substantial literature. Hence, once again, selectivity wins over comprehensiveness in an attempt to add value.

With respect to exchange rates, I briefly summarize, somewhat subjectively, the recent history of thought. The debate between fixed versus floating rages on, but a more effective approach, at least for the official community, would be to seek a set of standards for exchange rate management. This is no easy task and there is probably also no consensus, but to provoke discussion I provide a very schematic attempt.

Emerging market countries face many difficult trade-offs and one very clear one is that with respect to their liquidity positions. In the second section, I argue that due to the much tighter trade-off between monetary and financial stability for emerging countries, a strong liquidity position is essential, irrespective of the exchange rate regime in place. I present some figures for different countries on their actual liquidity positions but I also comment on the efficacy of the (recently available) public data. A strong liquidity position, however, has direct costs and may imply less domestic credit. In the final part of this section, I then discuss the role of the multilateral agencies in complementing a strong national liquidity policy—that assuages moral hazard concerns. This potential role for the IMF and the multilateral development banks1 is introduced to provoke discussion, as there appears to be no clear framework under which these organizations operate at the current time. In practice, however, these agencies are indeed fulfilling this role.

In the third section, I focus on the banking sector. Here, there has been so much general material written and so many “standards” now developed that I restrict comments to the experience in Argentina in implementing the BASIC framework for banking oversight. The BASIC framework attempts to employ both traditional banking regulation and supervision with some innovative techniques to enhance market monitoring and discipline. The last section concludes my discussion.

Fixed Versus Floating, Again

Despite a substantial literature devoted to the topic of the appropriate choice of exchange rate regime, the issue remains as unresolved and controversial as ever. Indeed, it currently appears that the debate, helped by history and circumstance, has come full circle. In this section I present a somewhat subjective review of where we are and an appeal on how the future debate could be structured. To arrive at this point, however, some history is useful.

On the Death of Fixed Rates

During most of the period covered by the system set up by the 1944 Bretton Woods agreement, the general sentiment was that fixing exchange rates, with some measure of capital controls, was superior to floating. The argument was normally couched in terms of the potential volatility of a floating rate regime—reflecting the experience of the inter-war period. An often-cited early exception was Milton Friedman, who argued for floating rates. Friedman suggested, for example, that the market would most likely do a better job than a group of bureaucrats in finding the appropriate level for such a fundamental price.2

As the system came under strain, it also became increasingly apparent that fixed rates, coupled with domestic price rigidities, implied costly adjustment to real shocks. This observation set in motion a train of thought, which resulted in what now might be referred to as a set of traditional arguments to determine the optimality of fixed or floating rates.3 Robert Mundell himself was unconvinced that floating rates would make the world better off but attempted to elucidate the conditions under which this might be the case. In one of the great ironies of economics his conditions have generally been used by those in favor of floating rates to argue against fixed! Among other arguments, Mundell claimed that the extra dimension of “flexibility” that some assumed would be present under floating was illusory and he furthermore considered that many of the underlying assumptions of his model were likely to be invalid. For example, his model assumed price rigidities and factor immobility, which he considered very strong indeed. His view was that such rigidities were likely to be endogenous to the monetary regime in place in the sense that, if the price of money was fixed, then other prices would become more flexible and factors would become more mobile. However, the breakup of the fixed exchange rate system under the Bretton Woods agreement demonstrated the potential problems of fixed regimes subject to large external shocks and unconvincing domestic discipline.

On Intermediate Regimes

After Bretton Woods, floating rates (as suggested by the inter-war experience) also appeared to policymakers to be “too volatile” given fundamentals. The different attempts to stabilize Group of Five (G-5) rates can be seen, to varying degrees, as manifestations of the dissatisfaction of floating rates in a world in which trade had grown substantially.4 However, the October 1987 stock market crash (which some blamed on an “uncoordinated” German interest rate rise) and the U.S. Federal Reserve’s swift action to ensure sufficient banking sector liquidity led to a dollar depreciation beyond the “Louvre” limits and subsequent zones (implicit rather than explicit) appeared then to have little effect.5

During this period, the perceived “excess volatility” of floating rates led some to propose “intermediate solutions.” The idea was that these intermediate systems might capture the benefits in terms of the flexibility of floating rates, letting the market function to some extent to find the “right level” but, at the same time, controlling the “excessive volatility” that appeared to follow from pure floating.6 The various stages of European monetary arrangements can also be seen as reflecting the dissatisfaction with volatile floating rates within the context of developing a single market. The development of the Exchange Rate Mechanism (ERM) of the European Monetary System (EMS) might be regarded as one of the most highly developed intermediate solutions: a self-adjusting band depending on the movement of its member currencies with relatively frequent realignments—at least in its earlier, softer guise. At the same time, many developing countries adopted intermediate solutions including pegged rates, crawling pegs, and crawling bands—Williamson and Miller’s favored regime.

However, once again history intervened. The breakdown of the ERM in September 1992, the Mexican devaluation of December 1994, the Southeast Asian devaluations in 1997-98, and the Brazilian devaluation of 1999, forced a fundamental reexamination of the vulnerability of such intermediate systems to speculative attack and, more generally, of the sustainability of pegged rates that are not supported by appropriate monetary rules. In part, this was seen as a consequence of the enormous growth in capital flows and their potential to render central bank interventions to maintain a fixed rate as futile.7 As a consequence of this quite extraordinary period of forced floating, calls for the “corner solutions” became increasingly vocal. The corners were considered to be a relatively pure float, or a very firm fixed rate regime, backed by a currency board (to ensure a monetary rule consistent with the fixed rate), or even monetary union.

On the “Corner Solution”

Several European countries chose one corner solution: full monetary union.8 Although the adoption of European Economic and Monetary Union (EMU) clearly reflected political aims, at the same time, it reflected the idea that while the lighter discipline of the ERM proved to be unsustainable, the harder disciplining force of monetary union would bring the reforms necessary to make the system dynamically stable. Indeed, the EU Maastricht treaty’s economic convergence criteria appeared to set in motion a virtuous circle, whereby policymakers let themselves be judged according to those criteria and the markets judged policymakers by whether their country would comply or not. This set in place strong incentives for reform and those reforms were rewarded by lower interest rates, making convergence easier.

But the advice stemming from Washington toward emerging market countries appeared to favor the floating end of the spectrum. Although the corner solution theory appeared in many discussions and speeches, the flexible corner appeared to be shouted loudly while the fixed corner tended to be whispered softly—to be recommended only in some particular cases. The Group of Twenty-Two (G-22) document on international financial crises is a good example in this regard and the emphasis is also noticeable in a recent paper by IMF staff including Michael Mussa (2000)—required reading for all interested in exchange rate management issues.9 Apart from Europe, which appeared to be heading in the opposite direction, and a small group of currency board countries (e.g., Argentina, Bulgaria, Estonia, Hong Kong SAR, Latvia, and Lithuania), the conventional wisdom appeared to be floating rates coupled with some method of conveying how (independent) monetary policy would be conducted (e.g., through an inflation targeting regime).

This system has been formally adopted by several industrialized countries (e.g., the United Kingdom, New Zealand, etc.) and also by some emerging market countries (notably Brazil, Chile, and Mexico). The proponents of this type of regime suggest that the inflation targeting regime will provide a nominal target and an accompanying “inflation report” will provide an excellent method to convey to the markets the analysis and thinking of the central bank, but the flexibility of the exchange rate will allow more efficient adjustment to shocks. It is probably fair to say that, to date, there have been some positive and negative experiences with this type of regime but that, given the limited experience, the jury is still out.10

One concern regarding pegged rates appeared to be the use of official (e.g., IMF, multilateral development bank, and bilateral) resources in supporting such regimes and the potential losses that then might accrue due to their subsequent failures. Indeed, the U.S. Treasury Secretary has stated explicitly that the IMF should not finance unsustainable fixed rates. This concern appears closely related to the more general “moral hazard” debate. On the one hand, there might be a perception that if relatively soft multilateral money is available to finance pegged rates, countries may have reduced incentives to “do what it takes” themselves to ensure the sustainability of the policy regime. Secondly, the private sector might expect the IMF or others to always continue to provide reserves to finance the fixed rate. This concern is clearly somewhat different from the question of whether a fixed or a floating rate regime, correctly designed and implemented, is superior or safer for emerging countries. However, a fixed rate supported by a very clear rule, such as a currency board, and supported by a comprehensive liquidity policy (as discussed in the next section) should help to alleviate such concerns.

The “corner solution” debate is very much a hark back to the old debate regarding fixed rates or monetary union versus floating. The element that has changed perhaps is the perceived nature of the shocks. During the Bretton Woods era, trade had grown substantially and those that argued in favor of floating rates stressed that asymmetric trade shocks implied that fixed rates or monetary unions would be suboptimal. In the 1990s financial flows grew enormously and today the focus is on both trade and financial shocks. A now standard argument is that the Mundell-inspired models should be updated to include potential financial shocks for those countries that receive substantial capital flows and have considerable international debt.11

On Dollarization

A distinct group of economists remains skeptical of the standard Washington advice to emerging countries.12 Indeed, this group appears to favor not only a hard fix but possibly even full monetary union with a hard currency, or “dollarization.” While the floaters tend to emphasize the potential dangers of unsustainable pegs, the valid use of exchange rate depreciation as a type of “safety valve,” and the benefits of “extra flexibility” that floating brings, this group tends to stress the disciplining effect of truly fixed rates and the difficulties emerging countries might have in pursuing an independent monetary policy and hence gaining the advertised “flexibility” of floating rates. In particular, they have pointed to the very different way in which emerging countries appear to float relative to Group of Ten (G-10) countries—that is, with much lower exchange rate volatility and higher reserve or interest rate volatility. And they suggest that the high degree of de facto dollarization in emerging countries is both a potential explanation for this revealed preference on how floating occurs (i.e., through greater interest rate adjustment and less currency adjustment) and also implies that the safety valve view of a depreciation might come at such a cost that it is not a safety valve at all. Moreover, they tend to suggest that fixing to a hard currency will reduce prudential risks (such as maturity or currency mismatches—see next section) and hence reduce credit spreads in dollars, making financing cheaper, and increase trade and financial integration and growth.13

Inconclusive Empirical Studies

Given the rich experiences of many countries with different exchange rate regimes, one would think that there would be clear empirical evidence on which regime results in better and safer economic performance. However, such studies have tended to give surprisingly inconclusive results. These results have been obtained depending on different samples and different specifications and with varied attempts to control for other cross-country variations. Although some early studies showed, for example, that the volatility of real exchange rates was higher under flexible and that inflation was higher under flexible, others have found insignificant differences. In general, there appears to be little significant evidence either way relating the choice of exchange rate regime to economic growth or other economic variables.14

Is There a Clear Trend Toward Floating Rates?

Intermediate solutions appear to have lost considerable ground in the academic “corner solution” debate. In practice, however, it is striking to note that there are still a number of countries that remain in the middle ground—including pegged rates without the backing of a currency board or crawling pegs or bands. Moreover, comparing the number of countries with floating, fixed, and intermediate regimes, it is not obvious that there is currently a strong trend toward the corners or torward floating—the floating corner in particular.

In Table 9.1, I give statistics based on IMF data using the 1999 International Financial Statistics classifications and reclassifying the 1995 IFS categories as closely as possible along similar lines).15 In the Appendix to the paper, I provide the classification of countries adopted.

Table 9.1.Exchange Rate Regimes


Total181 2185100100
Source: Author’s classification according to IMF data, International Financial Statistics, 1995, 1999.

We include the 11 euro countries in both columns.

In the IMF’s International Financial Statistics, total comprises 179 countries; we also include Hong Kong SAR and Brunei Darussalam.

Source: Author’s classification according to IMF data, International Financial Statistics, 1995, 1999.

We include the 11 euro countries in both columns.

In the IMF’s International Financial Statistics, total comprises 179 countries; we also include Hong Kong SAR and Brunei Darussalam.

Curiously, comparing 1995 to 1999, there appear to be fewer countries now with floating rates than in 1995 and more countries adopting intermediate systems or hard fixes. Naturally, this analysis is based on a simple comparison of two dates and the numbers presented are simple sums (not GDP-weighted, etc). However, I have also attempted to be fair to the “pro-floaters” in that the European Economic and Monetary Union (EMU) countries are counted as fixed in both 1995 and 1999. Treating several EMU countries as fixed in 1999 but intermediate in 1995 would tilt the results further toward more countries adopting fixed rates (and would have an effect on any GDP weighting results too).

The idea of including Table 9.1 is not to make too much of the apparent trend toward intermediate or fixed systems but rather to state that it is not so obvious that there is a strong trend toward the corners or floating. In view of this, it is not so surprising that some have expounded more compromising views on exchange rate regimes. There are several ways in which compromise positions might be presented.

On Compromise Positions

One compromise position is that there are good and bad fixed rate regimes, good and bad floating regimes, and even good and bad mixed cases. The real point of those that take this position is that the exchange rate regime is only of secondary importance. More important is the right set of supporting macroeconomic and other policies. For example, if the fiscal position is cautious, debt levels are not too high, debt maturities not too short, banking systems are strong, and prices reasonably flexible, then perhaps the choice of exchange rate regime matters less. Whatever exchange rate regime it is, it will be a success. This argument, although highly diplomatic, appears to be ducking the issue. While it is most certainly true that there are surely good and bad fixed and good and bad float, it seems likely that there is a possible ordering between good float and good fixed as well.

A second compromise position is that the choice of regime depends on particular country characteristics. This might lead to hard fixed, pure float, or indeed even some intermediary solution given particular circumstances and, perhaps, as a transition phase to another regime. The question then revolves around these particular characteristics and the extent to which they are really exogenous. I will come back to some characteristics of emerging market countries and their implications below.

Toward a “Standards” Approach

Academics tend to make a name by taking extreme positions and hence it is not surprising that there are strong divisions between those favoring purely floating rates, perhaps with an inflation targeting system to tie down expectations, and those favoring firmly fixed rates through currency board arrangements or even full monetary union or “dollarization.” In my view, however, it is time to initiate a new debate—perhaps one that will win fewer headlines but is consistent with approaches elsewhere. This third compromise position would take seriously the official position of the IMF that the choice of exchange rate regime is a sovereign decision of each country. Starting from this standpoint, the obvious way forward is then to seek a set of consistent rules or “standards” regarding exchange rate management. This would officially endorse different exchange rate arrangements but would establish a set of guidelines such that inconsistencies between the exchange rate system and the monetary policy rule (or other aspects of policy) would be ruled out.

Here the obvious starting point is the old adage that countries can only choose between two of the following: (1) a fixed exchange rate; (2) an independent monetary policy; and (3) an open capital account. Thus, countries that adopt fixed exchange rates and where the capital account is relatively open should adopt a fixed monetary rule such as a currency board mechanism. On the other hand, the rule implies that countries prepared to maintain relatively closed capital accounts may be able to find a combination of a pegged rate regime and some monetary independence.

More controversially, Cooper (1999) proposes that there is a potential inconsistency between (1) floating exchange rates, (2) independent monetary policy, and (3) open capital accounts—at least for countries with small and poorly developed domestic capital markets (i.e., most emerging countries). Cooper’s argument is essentially that shifts in sentiment, or even worse, a single speculator might move an exchange rate sufficiently to start an unstable dynamic in a country with such characteristics. If the central bank accommodates the move, then the process may lead to many different equilibria, some with huge exchange rate swings and consequent effects on monetary and price stability. If the central bank does not and, for example, attempts to defend an inflation target, in a small open economy where there is presumably significant pass-through, then a familiar game between the resolve of the central bank to defend a target and that of the market, betting that it will at some point give way, will ensue. To a significant degree this game may have similarities to the defense of an exchange rate peg/band. As Cooper states, this implies that there may be a strong tension between the two prescriptions regularly extended to emerging countries by the official community: to reduce capital account restrictions and to adopt floating exchange rates. One interpretation of the Cooper (1999) view is that countries that wish to float need to drive some type of wedge between domestic and foreign financial assets, to give domestic monetary policy some bite. A tax on capital imports, for example, might be such a policy intervention along these lines. However, naturally there would be a cost to pay for such a policy in an emerging country that needed foreign capital. The other corner solution would be a firm commitment to a fixed rate through a currency board or even full monetary union, in which case the country might be able to have a fully open capital account.

A set of detailed standards is clearly well beyond the scope of this paper and a set of highly detailed standards might require several hundreds of pages depending on the detail entered. However, a set of simple, consistent rules certainly does not seem beyond the bounds of possibility. To provoke discussion, I present in Table 9.2 my very schematic outline of some very basic rules for fixed versus floating exchange rates. In the case of fixed exchange rates, the rules—I would advocate—are relatively clear. If a country wishes to have a fixed exchange rate and a completely open capital account, then monetary policy must be tied precisely to maintaining the exchange rate target. In this case, a currency board or even full monetary union or “dollarization” are to be recommended.16 In the next section, I discuss further liability management strategies. Here, suffice to say that if a currency board or monetary union is adopted, then a consistent liability management strategy is to seek to minimize liquidity risks by issuing long-term debt when in foreign currency, as currency risks are less important.

Table 9.2.Standards for Exchange Rate Management
Fixed Exchange Rate Strategies
Fully open capital account
  • Currency board, monetary union, or similar.
  • Liability management strategy to reduce liquidity risks through seeking longer maturities in foreign debt.
Capital import taxes or other capital account interventions
  • Pegged rate with minor monetary flexibility.
  • Need for authorities to communicate to the market monetary policy objectives and to ensure consistency of overall policy stance.
Floating Exchange Rate Strategies
Fully open capital account
  • Need for authorities to communicate to the market monetary policy objectives through an inflation targeting system or otherwise.
  • Need to ensure the widest feasible availability of hedging instruments.
  • Need to develop contingency plans (including monetary policy and banking sector responses) for periods of high exchange rate volatility and potentially unstable exchange rate dynamics especially if balance sheet effects of exchange rate movements are significant.
  • Liability management strategy mixed, trade-off between degree of “dollarization” and liquidity risks.
Capital import taxes or other strong capital account interventions
  • Need for authorities to communicate to the market monetary policy objectives through an inflation targeting system or otherwise and to ensure consistency of overall policy stance.
Note: All countries should develop a set of sound financial (and, especially, banking) regulations; emerging countries, irrespective of the exchange rate regime, should develop a systemic liquidity policy.
Note: All countries should develop a set of sound financial (and, especially, banking) regulations; emerging countries, irrespective of the exchange rate regime, should develop a systemic liquidity policy.

If, however, the country in question wishes to impose capital account restrictions, then this might allow a fixed rate with some minor degree of flexibility in monetary management. I do not go into detail here as to how this monetary flexibility might be conducted. It is absolutely paramount, however, that the authorities should communicate to the market the rules for such monetary management and put in place safeguards to ensure that monetary policy remains overall consistent with the exchange rate stance.

In thinking about this table, perhaps the more interesting question is what supporting policies countries may need to pursue if they adopt floating exchange rates. First, let us consider the case of a fully open capital account. First, it is, in the view of the author, to be highly recommended that the authorities communicate to the market how monetary policy will be conducted through an inflation target or otherwise to ensure that the economy has some nominal anchor. Second, given the experience of G-10 countries’ floating rates it would certainly be advisable for non-G-10 countries to attempt to develop markets in vehicles for foreign currency hedging. However, the author remains suspicious that, in the case of an emerging country that has a very steep yield curve in domestic currency and (therefore) issues very little foreign debt in domestic currency, it will really be feasible to develop a liquid market for hedging medium-term currency risks. If this view is correct then the country in question may also need to develop a contingency plan for periods of high exchange rate volatility. This will be a particular need in the case of countries that have significant currency mismatches in the public sector, in the financial sector, or in the nonfinancial private sector. As dicussed above, there is a growing literature that opines that floating emerging countries in fact do not float in the manner that, say, G-3 countries’ exchange rates float because emerging countries that suffer from such currency mismatches would face very severe financial problems. If this is the case, then these “floaters” may not be gaining the advantages from floating even though they have ostensibly adopted floating rates. The above suggestion is then closely related to this view—that is, that countries may need to develop strategies that would really allow such countries to truly float. As discussed further in the next section, an emerging country that attempts to adopt a floating exchange rate with an independent monetary policy will, in general, wish to develop a mixed liability management strategy that trades off currency risk concerns with liquidity risk concerns. In other words, while issuing longer term in foreign currency will reduce liquidity risks, it will also increase currency risks. However, issuing too much debt in local currency will (all things being equal) increase liquidity risks. We also note that having too much debt in foreign currency or having too much short-term debt will both complicate domestic monetary control. There is then a set of complex trade-offs for liability management in this regime.

Cooper (1999) suggests that emerging countries wishing to adopt floating rates may also need to think in terms of some capital account restrictions. Here, once again it would be imperative to communicate to the market in the clearest way possible the objectives and instruments of monetary control. Moreover, similar trade-offs would be involved for liquidity management as in the case of a floating rate with an open capital account. However, in this case, the assumption would be that currency volatility would be lower and hence there might be a presumption toward lowering liquidity risks through issuing at longer terms in foreign currency.

Concluding Points

The above discussion highlights the fact that history has played an important role in shaping our thinking with respect to exchange rates. Indeed, it seems that regardless of the dominant exchange rate arrangement in force at the time, it was deemed unsatisfactory—whether it was the gold standard, floating rates between the wars, the Bretton Woods fixed rate system, post-Bretton Woods floating, or intermediate systems such as pegged rates/bands in Europe or in emerging countries. The trend toward floating rates has been endorsed by many official statements but, at the same time, the volatility of G-3 rates does not bode well for emerging floaters. For example, the euro has depreciated by over 25 percent since its inception and, according to European policymakers, this trend is not justified by the fundamentals.17 This volatility in G-3 rates has been very harmful for emerging countries. At the same time emerging countries that float appear to have much lower volatility—they have a “fear of floating” to use the title of Calvo and Reinhart’s paper. One interpretation is that a partially dollarized emerging country floater cannot withstand the balance sheet effects of pure floating, given the potential volatility, reducing the value of such a system.

To summarize the state of the current debate on exchange rate arrangements, it appears to remain as controversial as ever, with some taking strong views toward fully fixing to pure floating. Those with more compromising souls expound the “corner solution” theory, with the correct corner depending on individual country characteristics. Others compromise by relegating the importance of the choice and stressing the importance of maintaining a sound general macroeconomic environment. One way forward to obtain a safety-first strategy—and yet one that is acceptable to the world community—would be to take seriously the IMF view that the choice of exchange rate regime should remain the choice of the country but the set of supporting policies or “standards” adopted should depend on the choice of exchange rate regime. There is widespread consensus that a fixed exchange rate, an open capital account, and an independent monetary policy are incompatible. Hence, for countries that fix but wish to have an open capital account, a currency board or even “dollarization” might be recommended. However, more controversial is the view that an independent monetary policy, a flexible exchange rate, and an open capital account may also be inconsistent. In October 2000, the G-20 Ministers may make some pronouncement on this issue; the “standards” approach would appear to be a useful way for the international community to go.

Link Between Monetary and Financial Stability: An Emerging Country Perspective

In this section, I attempt to consider the link between monetary and financial stability from an emerging country perspective. The main thesis in this section is that the emerging economies tend to have a much tighter trade-off between monetary and financial stability than a typical G-10 country does. A way of resolving this policy dilemma is to develop a systemic liquidity policy. Designing such a policy becomes somewhat similar to the traditional question: what level of international reserves should a country have? A standard response would be that this depends on the exchange rate system in place, but the following discussion suggests that even in a floating exchange rate regime, emerging countries should certainly maintain higher reserves than their G-10 counterparts as the trade-off between monetary and financial stability is still very real.18 In practice, emerging countries do appear to heed this advice, as they do appear to hold very significant reserves (even floaters). In the first section, I will consider the specific case of the banking system and then widen this to liability management more generally. I will consider a recently made available dataset to consider countries’ liquidity positions but also present some purely theoretical calculations. The section finishes with a brief discussion of the role of the multilaterals in complementing a domestic systemic liquidity policy.

Systemic Liquidity Policy for Emerging Country Banking Sectors

The trade-off between monetary and financial stability is well known in central banking circles. The normal solution to this problem is to ensure a regulatory regime that gives bankers the right incentives to control risks and to maintain adequate solvency ratios—I come back to issues regarding banking regulation below. Given the right incentives, the argument runs, on the one hand, there is then little chance of a banking sector problem affecting monetary policy (through the need to inject liquidity into banks) and, on the other hand, if a tight monetary policy and high interest rates are required to combat rising inflation, then this will not place the banking system in jeopardy.19

High solvency ratios and the right incentives do not imply zero risk, however. Indeed, a banking system that has so much capital that it is perfectly safe is also an inefficient one. The crises in banking systems in countries with high quality levels of regulation and supervision show that real risks will remain in any country. Moreover, recent research and official advice tends to favor strictly limited deposit insurance—if explicit at all.20 In this environment, monetary authorities must always be aware of the potential need to inject liquidity into a banking sector and there will then always be some potential trade-off between maintaining financial stability and monetary stability.

In a G-10 country, it is quite possible to think of a central bank injecting liquidity into the banking system but at the same time sterilizing that injection through the sale of government bonds. This may allow a country to “recycle” liquidity, with an injection to the banking system but at the same time increasing government debt to sterilize to protect monetary stability (i.e., to protect a monetary, inflation, or exchange rate target). However, in the context of an emerging country this is simply unrealistic. Given any significant problem in the banking sector, there will almost inevitably be a switch from domestic to foreign assets and almost inevitably government bond markets will become increasingly illiquid. An injection of local currency liquidity will then be carried out at a time when there will be no demand for domestic currency assets and the central bank runs the very real risk (some would say certainty) of aggravating the problem rather than solving it. This means that, although the injection of domestic liquidity may be necessary to keep the banking system alive in terms of liquidity, the liquidity injection will depreciate any floating exchange rate dramatically (and place any fixed rate at severe risk), thus potentially rendering insolvent any company (or bank) with a significant currency mismatch. The currency substitution and the lack of any realistic ability to sterilize under these conditions imply that emerging countries face a much harsher trade-off than a G-10 country between monetary and financial stability. For this reason, liquidity for the banking sector (and not just solvency) is an extremely important issue for emerging countries. And one potential way out of this dilemma is to develop an explicit liquidity policy.

To a significant extent, these problems were evident in the crisis-hit countries in Southeast Asia. Although there were initial solvency concerns as well, it is clear that these were amplified tremendously by the violent exchange rate moves following the injection of substantial quantities of liquidity to save banking systems. It is now equally clear during the recovery phase how important this liquidity shock was. It seems doubtful that sufficient time has elapsed for the relevant countries to have implemented the fundamental reforms that some analysts deemed necessary. And yet, many Southeast Asian countries are recovering extremely well, highlighting the fact that a major cause of the “crash” in banking systems, credit flows, and GDP was illiquidity. The conclusion is that if these countries had had an explicit “ex ante” liquidity policy in place, then they would most likely have suffered much less in terms of the disruption to credit intermediation, exchange rate overshooting, and consequent solvency problems due to currency mismatches.

In 1995, Argentina also experienced a sharp liquidity shock and banking sector crisis in response to the 1994 Mexican devaluation, which ultimately led to a serious recession. After that experience, the central bank has developed a “systemic liquidity policy” to protect Argentina’s financial system from reoccurrence of such an event. What does this policy consist of? First, banks are required to maintain some minimum percentage of both Argentine peso and dollar deposits and other short-term liabilities in the form of external liquid assets. According to the rule, for liabilities of residual maturity of less than 90 days, banks must maintain 20 percent of such assets on reserve, with that percentage decreasing to zero for residual maturities of more than one year. Second, the central bank has attempted to provide “systemic liquidity” to other domestic assets on banks’ balance sheets. By “systemic liquidity” we mean liquidity even in the face of a systemic shock. Hence, the central bank has negotiated a contingent repurchase agreement (repo) with international banks to be able to repo domestic assets for cash in dollars in a time of stress. This contract covers government bonds, to some $5.6 billion, and Argentine mortgages for some $500 million (a total of about 8 percent of the deposit base—this excludes a $1 billion enhancement provided by the World Bank and the Inter-American Development Bank to this facility).21 This implies that today, the Central Bank of Argentina could inject up to some 28 percent of the deposit base in hard currency liquidity into the banking system (through the reduction of liquidity requirements and using back-to-back repo operations with domestic banks and the negotiated foreign repo line) without any effect on the 100 percent backing of the monetary base with international reserves maintained today.22

Such a liquidity policy clearly has its costs. The liquidity requirements imply a reduction in the total lending capacity of the domestic financial system and an opportunity cost for banks. A simple calculation of the opportunity cost for banks is as follows: the prime lending rate in Argentina is close to 8 percent (in U.S. dollars, which is the most relevant) while the liquidity requirements are remunerated at just under short-term international rates—say, 5 percent, implying an opportunity cost of 3 percentage points. A liquidity requirement of 20 percent then costs some 0.6 percentage points for each $1 of deposits or each 80 cents of lending.23 It is interesting to compare this cost with that of the contingent repo facility with the international banks, which attracts a commitment fee of some 35 basis points on average. Thus, to establish a line for 20 percent of $1 of deposit implies a cost of just 7 basis points—about 10 percent of the cost of the liquidity requirements.

It is clear that liquidity in contingent form (i.e., buying insurance) is then substantially cheaper than maintaining reserves (i.e., self insurance). It also does not have the same cost in terms of reducing the lending capacity of the domestic financial system. A counterargument is that such lines reduce the amount of capital to an emerging country, given that international banks maintain some finite country limits and there may be crowding out. This direct effect depends critically on how banks treat lines that are (1) more than fully collateralized by assets that may be settled outside Argentina (although they are Argentine assets); (2) contingent; and (3) enhanced by the World Bank and the Inter-American Development Bank.24 The central bank attempted to minimize these crowding-out effects and, indeed, developed a policy on pricing such that banks that count such lines equivalent to straight loans (and hence where there may be strong crowding-out effects) were not selected to participate.

However, it is our view that the liquidity policy put in place (liquidity requirements and the repo facility) has actually “crowded in” credit to Argentina very significantly. Since the liquidity policy was formulated in 1995, the financial system has almost doubled in size. Moroever, given the turbulence in international financial markets (including in Argentine country risk spreads) over the last two years or so, the lending capacity of the system has also continued to grow. In our view then, the systemic liquidity policy, although implying some direct costs, has helped to “crowd in” domestic credit. Hence, by reducing the costs of the financial system through enhanced economies of scale, this policy has been a net benefit rather than a net cost for the banks. Of course, this policy has also implied that there has been a strong cushion of liquidity insurance available in case of any liquidity shock—thankfully, not required since the 1995 experience.25

Liability Management

Now, let me turn more generally to liability management. Here, I want to consider the links to monetary and financial policy and liability management in both the public and private sector from the standpoint of emerging countries.

The analogy of the tendency toward foreign currency substitution on the asset side is the difficulty that emerging countries face in attempting to issue liabilities in domestic currency. In practice, most emerging country borrowers face very steep yield curves in domestic currency.26 This gives rise to a choice—which might be referred to as the devil’s choice. Emerging countries either may issue debt more cheaply in foreign currency or they may issue in domestic currency, but where the costs dictate (or simply the lack of markets dictates) that maturities will be short. This is a devil’s choice as it inevitably leads to currency risk, liquidity risk, or (most likely) both.27

The first thing to note is that both solutions make monetary policy more problematic. A stock of significant short-term debt denominated in domestic currency implies that a strict monetary policy may increase the risk of an unstable debt dynamic and hence make a strict monetary policy—perhaps in the defense of an exchange rate or inflation target—less credible. On the other hand, a significant dollarization of debt leads to substantial currency risks such that the idea of a purely floating exchange rate also becomes less credible—as the balance sheet effects of a substantial exchange rate depreciation become more significant.

However, it is also clear that the way to correctly manage liabilities will depend to some degree on the exchange rate regime chosen. For example, if a truly fixed exchange rate is adopted, then it may be more appropriate to focus on reducing rollover risks and issue more and at longer maturities in dollars or other foreign currencies. At the limit, the adoption of full monetary union with a hard currency (e.g., dollarization) implies that there are no currency risks to issuing in the hard currency. On the other hand, if a country is attempting to run an independent monetary policy with a floating exchange rate, there may be more of a case to issue debt in domestic currency.

However, this will tend either to be more expensive or at shorter terms or both, and hence may give rise to problems of monetary control. Of course, if countries have a significant number of captive domestic investors—normally, domestic banks or pension funds or other domestic financial institutions or through a system of capital controls—this trade-off may be ameliorated. However, to the extent that such investors are captive and are forced to hold government debt at “subsidized” rates, this must harm the balance sheets of these institutions and undoubtedly will have significant costs elsewhere in the economy, which should be considered. Whether these costs are justified in terms of the greater monetary control achieved becomes the relevant question. This comes back directly to Cooper’s position—that an independent monetary policy and an open capital account may be inconsistent.

A second way forward is to establish a liquidity policy such that debts coming due within a certain period are covered by reserves. This policy might be seen as either one to control pure rollover risks or to make more credible an independent monetary policy in the face of significant short-term domestic currency debts—in other words, reducing the possibility of generating an unstable debt dynamic. Alan Greenspan, chairman of the U.S. Federal Reserve, has made reference to the Guidotti rule (after Argentina’s former secretary of finance, Pablo Guidotti) that a country should have reserves to cover debts coming due over the next 12 months.28 In fact, in Guidotti (1999), it is suggested that one of the qualifying conditions for the IMF’s then new Contingent Credit Line (CCL) might be that a country’s reserves plus the maximum access to the CCL (to be determined as a percentage of that country’s quota) should cover 12 months of all government debt coming due.

I stress the fact that this rule should cover both domestic and external debt for two reasons. First, a problem in domestic capital markets can very quickly translate into a problem in external markets; hence, to ignore a potentially unstable domestic debt dynamic appears simply incorrect on economic grounds. Second, considering only external debt is giving the signal, albeit implicitly, that external debt might be considered senior to domestic debt. A response to this might be that in a floating exchange rate world a large depreciation would imply that domestic debts become much lower in dollar terms. However, this view is virtually certain to be inconsistent with any monetary or inflation target and is obviously inconsistent with an exchange rate target. One view would be that for a country with an inflation target and a floating rate, reserves should cover 12 months of total debt coming due given the maximum depreciation consistent with the inflation target in place. This will depend on the particulars of the country involved.

Given the experience of Asia and also previous experience in Latin America in the 1980s, the liabilities of the nonfinancial private sector should also not be forgotten. Here, a relatively noncontroversial opinion is that, at a minimum, such liabilities should be monitored and (once again) this should refer to all liabilities, not only external ones. Obviously, there are certain technical difficulties involved here and, for example, derivative transactions can distort the picture. Still, it does not seem an impossible task to develop a monitoring system that gives a useful, if not perfect, picture of private sector indebtedness and yet not all countries have even begun to implement such monitoring procedures.

A more controversial suggestion is that corporate indebtedness should be controlled in some sense—for example, limiting foreign currency indebtedness—or that authorities should include the nonfinancial private sector in developing an overall liquidity policy. If the incentives are correct for managers and shareholders to ensure that corporate risks are managed effectively (and that implies reasonable corporate governance and no implicit insurance) then, from a purely prudential standpoint, the arguments for some form of direct control on corporate liabilities or a liquidity policy are certainly weaker than in the case of the banking system, which is normally considered much more systemic. Such arguments would have to show that there was some kind of externality created by the individual actions of many corporate entities in contracting foreign debt and that intervening would bring greater rewards than costs. I leave this as an open question.29

However, there may also be an argument for limiting corporate external indebtedness—not from a prudential point of view, but rather from a monetary control point of view. In other words, the same argument as above, that a high degree of dollarization (this time among corporates) might limit the potential of independent monetary policy action, appears relevant. Once again we are back to Cooper’s point (1999)—that independent monetary policy and an open capital account might be inconsistent. This is one interpretation of the Chilean-type zero remunerated reserve requirement on capital inflows. In fact, the Chilean system (lifted since 1998) is a mixture of a liquidity tool (in that it increases the reserves of the central bank) and a tax, possibly reflecting mixed objectives.30 A whole spectrum of potential interventions along a dimension from pure remunerated liquidity requirements to pure taxes could be considered depending on the mix of objectives. If the objective is purely prudential, then the relevant intervention might be a liquidity requirement with a zero tax component (along the lines of the Argentine liquidity requirements), whereas if the objective is purely monetary control, then the relevant intervention might be a pure tax. Those that argue in favor of the imposition of some sort of tax to gain monetary control need to demonstrate that the benefit of the increased monetary independence so attained by this type of policy outweighs the negative effects of the tax on capital inflows on investment and growth.

Developing an Overall Liquidity Policy: Preliminary Ideas

In this final subsection, I attempt to give some preliminary ideas as to what a systemic liquidity policy might look like for a “typical” emerging country. To do this, I first present some of the data that have recently been made available and make some observations regarding its efficacy, I then present a purely theoretical calculation, and finally I discuss the role of the multilaterals in aiding countries to develop such a liquidity policy.

Using (Recently Available) Easily Found Public Data

In enhanced efforts to monitor countries, debt, and reserve positions, the IMF, Organization for Economic Cooperation and Development (OECD), Bank for International Settlements (BIS), and the World Bank have cooperated and made available an extremely useful dataset on the Internet (interested parties may log on, for example, to the OECD’s website at to find this data). The database appears to be set up to compare countries’ “external” liquidity positions—in other words to compare either stocks or flows of external assets and liabilities. Following the discussion above, I will compare the stated level of reserves with external liabilities coming due within the next 12 months plus 20 percent of banking sector deposits.31 This is illustrated in Figure 9.1. This graph represents the latest technology available to monitor countries’ liquidity positions. As such, it represents a significant advance in that, previously, analysts had to look at different sources, consider different definitions, and attempt to aggregate to the best of their ability.

Figure 9.1.Estimated Liquidity Position: Selected Countries

(July 1999)

Source: Debt, OECD/IMF/WB/BIS joint database; Deposits, IFS

As discussed above, however, the calculation should be made with respect to all debt (not just external debt) and the figures thereby tend to overstate the coverage of reserves—especially in those countries with high internal debt levels. However, the figures do include the nonfinancial private sector and not just public and financial sector liabilities (there is no breakdown published along these lines in this joint multilateral effort) and so, implicitly, we are considering a wider liquidity policy in that regard. Consequently, countries with a higher proportion of short-term private sector debt appear to be in a relatively weaker liquidity position. Moreover, there is some double counting. First, the BIS data on securities coming due in the next 12 months includes the banking sector but this is also included in a separate row on banking sector liabilities coming due; moreover, there is not a sufficient disaggregation to disentangle the relevant amounts. There also is likely to be double counting in the banking sector data from the IMF and the external liability data from this joint multilateral effort, which is discussed further below.

Unfortunately, the definitions employed have further deficiencies. I would advocate that there are potentially useful definitions of external debt, where the most relevant definition depends on the question under analysis. A first definition might refer to currency of denomination (which might be relevant for questions regarding the risks inherent in currency mismatches and the outcome, for example, in the event of a significant devaluation). Second, there is a legal definition that refers to whether the debt was issued under local regulations or under the legal authority of another country (e.g., typically, U.S. or U.K. law—this might be a relevant definition to analyze what would happen in the case of a potential default: i.e., which instruments might be subject to which modes of renegotiation). A final definition is residence—that is, is the debt held by foreign or domestic residents? This is the relevant definition for thinking about the sustainability of the current account deficit, for example.

The BIS stock data use a nationality (otherwise known as a consolidated) criterion and a residence (otherwise known as a nonconsoli-dated) criterion. For the nationality criterion, the important element apparently is the nationality of the headquarters of the bank in question.32 To give an example, a dollar loan given by Citibank Argentina to an Argentine resident, booked in Argentina and funded by a dollar deposit in Argentina of an Argentine resident, is considered in this data as external debt. The residence criterion nets this out. Unfortunately, the figures for the banking sector for the amounts coming due over the next 12 months are only available on the nationality criterion. This substantially overstates the “external debt” figures for countries with significant banking sector liabilities and assets in foreign currency—like Argentina.33 Moreover, it also implies that there may be serious double counting in that the IMF banking sector deposits data may include deposits counted as external liabilities.

A second problem is the definition of reserves. Given that we are considering the liabilities of the public and private sector, the relevant comparison should, arguably, include any information available regarding private sector reserves. In other words, it perhaps should be a net liquidity position of the private sector that is relevant, not simply the debts coming due. At the very least, any known liquid reserves of the private sector should be included. In the case of Argentina, for example, some of the liquidity requirements are held offshore and these are not included in the reserve figures for the central bank. Finally, the BIS data refer not just to drawn lines but also commitments and, again, there may also be contingent liquidity available on the asset side (for example the Argentine contingent liquidity facility). Figure 9.2 presents a “corrected” comparison for the end of 1999 using official figures and where liabilities are defined correctly on a “residence” basis and reserves include the reserves of the banking system held offshore and the Contingent Liquidity Facility. (An alternative would be to include all of the foreign assets held by Argentines abroad.) In fact, in the case of Argentina, the currency board implies a different policy rule in that these reserves really back 100 percent of the monetary base plus a fraction of banking sector deposits. We include Argentina in Figures 9.1 and 9.2 for reasons of comparison only. In Figure 9.3, we show the actual functional rule, which is that the central bank backs 100 percent of MO plus roughly 28 percent of the deposit base.

Figure 9.2.Estimated Liquidity Position: Argentina

(Corrected information, December 1999)

Figure 9.3.Actual Currency Board Policy and Liquidity Position: Argentina

(December 1999)

Theoretical Calculations

The above data are a useful starting point but, unfortunately, can give a misleading picture depending on country characteristics. Presumably, as the quality of this data improves over time, these types of problems will be reduced. Let me now try to suggest the type of liquidity policy that I really have in mind, without the constraints of actual data availability, and the implications for emerging countries. Suppose an emerging country has a total public sector debt to GDP ratio of some 30 percent with an average maturity of five years such that 20 percent of that debt matures within one year; suppose monetary aggregate MO is some 2 percent of GDP and banking sector deposits are 40 percent of GDP.34 If we consider a liquidity policy such that reserves cover (1) public sector debt coming due within one year; (2) 100 percent of M0; and (3) 20 percent of bank deposits, this country would need to hold reserves of some 16 percent of GDP! Once again, this kind of calculation is highly arbitrary depending on the level of cover of each aggregate (M0, banking deposits, and debt coming due),35 and a sensitivity analysis could be conducted on these figures. But the main point is that this is a very substantial number (and excludes nonfinancial private sector liabilities) and very few countries have that level of reserves.

Another way to consider the problem is to suppose that the “typical” emerging country had reserves (or liquidity for 12 percent of GDP). For this to cover 100 percent of M0 and 20 percent of bank deposits, with a debt to GDP ratio of 30 percent, the amount of debt coming due in one year as a percentage of total debt could be no more than 6.7 percent. This kind of calculation might define a safety-first public sector liability management policy to be followed. More generally, one could express the policy in terms of a maximum percentage of banking liabilities (which could be influenced by appropriate liquidity incentive regulations on banks) and public sector liabilities to be coming due within the next 12 months.

On the Role of the Multilateral

It is also clear that liquidity shocks are not perfectly correlated across countries, however. Therefore, it would be extremely inefficient for each and every country to maintain such levels of reserves or to have the cost of extending debt maturities so high. This suggests that some central agency, most likely the IMF, has a very important role to play to complement domestic liquidity policies. These arguments are clearly related to the view that the IMF should see itself more explicitly as an international lender of last resort.36 However, the IMF should only act in this capacity given that countries themselves have appropriate prudential policies including an appropriate systemic liquidity policy defined in the fashion described above. Indeed the above suggests a widening of the Greenspan-Guidotti rule in that access to IMF facilities might be conditioned on the view that such access, together with the local liquidity policy, should provide an acceptable degree of cover for the various aggregates as suggested by the previous discussion. In Figure 9.4, purely for interest, we present such a comparison for Argentina including the current $7.2 billion stand-by arrangement agreed with the IMF. If we include this agreement, Argentina’s reserves (i.e., reserves of the financial system and the IMF stand-by arrangement) cover all of 12 months’ external debt coming due (public and private sector) and 20 percent of bank deposits.37

Figure 9.4.Estimated Liquidity Position: Argentina

(Corrected information including IMF stand-by arrangement, December 1999)

This is one way to think about the role that the IMF could play to complement a domestic liquidity policy. As mentioned previously, the World Bank and the Inter-American Development Bank have given the Central Bank of Argentina a $1 billion enhancement to a contingent liquidity facility.38 To the extent that this enhancement leverages up the private sector funds in the facility, these multilaterals are also playing a role in the overall liquidity position. This division of responsibilities between IMF resources, which in the case of Argentina act as a kind of fiscal backstop, and the multilateral development banks’ resources, which are leveraging up a backstop for the financial sector, raises a set of fascinating questions. The Group of Seven (G-7) and the Group of Twenty-Two (G-22) have both concluded that the multilateral development banks should attempt to “crowd in” the private sector and support contingent lines, but details are lacking.39 First, while the division of labor between the IMF and the multilateral development banks can be justified given the role of the latter institutions in financial sector development and the IMF’s more macroeconomic concerns, it would certainly be useful to open this debate and obtain a clear framework to define responsibilities. Second, it is not currently clear whether the standard instruments employed by the IMF and the multilateral development banks fit the actual job. For example, the multilateral development banks have essentially given a contingent loan to Argentina to enhance the contingent liquidity facility but it might be more efficient to use a guarantee structure. The World Bank now has a guarantee program but its use (and pricing), despite calls from the G-7 and G-22, still appears to be controversial. The IMF currently is reviewing its own set of instruments (“facilities”). This is an area where a clearly defined set of principles would be of enormous benefit both for the boards of the IMF and the multinational development banks, to know where their political masters might wish them to head, and for member countries to know which kinds of instruments, and from whom, might be available.

The Banking Sector

In the discussion above, I have considered exchange rate arrangements and liquidity arrangements without reference to other banking sector risks. There has been an enormous amount written recently on strengthening of the banking and financial sector and so it does not appear to be a useful exercise to repeat the main findings here.40 Rather, I will focus on the experience and lessons from Argentina and, in particular, the development and implementation of BASIC banking oversight as the system is now known.


The recent literature has rightly stressed the role of promoting the correct incentives. On the one hand, this requires a careful design of the safety net, most likely toward a limited but explicit deposit insurance scheme and guidelines on the central bank (or other) lender of last resort activities. On the other hand, it requires a set of prudential regulations that enhance incentives toward prudence.

A useful approach is a combination of both traditional regulation and supervision and market mechanisms. The roles of the banking sector supervisor and the market are highly complementary on at least two different levels: first, in terms of generating information and monitoring that information and, second, in terms of disciplining. One way to think about these complementarities is to note that there may be both “supervisory” failures and “market” failures both in terms of information generation and monitoring and in terms of disciplining.

BASIC Banking Oversight in Argentina

This complementary approach is enshrined in Argentina’s BASIC approach to banking oversight.41 In this system, the Superintendency shares the role of monitoring and disciplining banks with the market. BASIC is the acronym formed by the first letter of the names of the instruments employed in this interlocking system: bonds, (external) auditing, traditional supervision, information, and credit rating. In Figure 9.5, I present a more schematic representation of how the pieces of this policy fit together and below I discuss each in a more logical order.

Figure 9.5.Basic Banking Oversight

Information is a key element for banking oversight, by the market or by the Superintendency. The letter “I” refers to the information revealed on the performance of banks. With this in mind, Argentina’s central bank has developed a policy of publishing monthly the balance sheets, performance ratios (including earnings, costs, efficiency, and details of nonperforming loans), regulatory ratios (including provisioning, capital, and liquidity positions), and other relevant information on the banks in the system. The information is presented in absolute numbers and data for each bank are also compared with data for the system as a whole and data for a subset of similar banks. This information has now become a standard reference in the market and is available on paper, in CD-ROM format, and on the central bank’s website (

Further related to the issue of information, the central bank also has established a central Credit Bureau consisting of a set of related policies that first began in 1992 with a database of the largest debtors of the financial system. In the last three years, however, the central bank has significantly extended this database, which now consists of all loans in the financial system of more than $50 and related information.

The central bank disseminates information on the bad loans of the financial system (loans in categories three to six of the Argentine system of loan categorization) in a database format on a CD to financial institutions and private credit bureau companies. Moreover, the central bank publishes the entire database (good and bad loans) on a timely basis on the bank’s website.

The motivation for this policy is twofold: first, to increase the information available to banks and other financial institutions regarding the credit histories of borrowers (both commercial and consumers) and, second, to increase the “willingness to pay” of borrowers. Borrowers know that if their names appear in the central bank’s database in a “poor” category then, apart from any unease created simply by this information being available, they will most likely be denied future credit from the financial system or, at least, their cost of credit will rise.

Most recently, the central bank has sought to complement the basic credit information with more information regarding firms’ balance sheets and certain information pertaining to consumers’ ability to pay. This information will be distributed to financial institutions and private credit bureau companies so that they can develop more sophisticated models of credit scoring to further assist in credit-granting decisions.

In the Anglo-Saxon (United States, United Kingdom, etc.) policy discussions, such activities are normally carried out purely by private companies while in continental Europe there are several examples of credit bureaus in the official sector. (Moreover, I understand this issue is currently under discussion in the EU.) The view of the Central Bank of Argentina is that there are strong arguments for public intervention in the generation of the basic information as there are very strong economies of scale and the basic industry may be close to a natural monopoly. However, private credit bureau companies also have a very important role: not as “profiteers” from “monopoly rents” but rather to add value to this information by complementing it with other sources and/or developing credit scoring models and other products of interest to the credit markets.

External auditing plays a very significant role in bank supervision, since it allows the validation of the balance sheets presented by the banks to the central bank. The letter “A” is a reference to this component. Moreover, given the importance of the role of external audits, the Superintendency in Argentina has created a group whose main task is the control of the compliance with the external auditing regulations, which in turn are explained clearly in a detailed manual. Naturally, for the auditing function to operate well requires a sound set of accounting standards. The recent agreement on a set of international standards in this area should be a very significant advance indeed.

The letter “S” stands for the traditional regulation and supervision carried out by the Superintendency (a semi-autonomous unit within the central bank).42 Argentina has, in the last eight years or so, completely revised its banking sector regulations. In Table 9.3, taken from Calomiris and Powell (2001), I present a list of the main changes. In broad terms, the approach has been to adapt Basel regulations to local conditions, which normally involves higher requirements.43

Table 9.3.Main Regulatory Advances in Argentina (1991-99)
April 1991: Currency board adopted (backing of monetary base and exchange rate of Arg$10,000: US$1, subsequently 1:1).
September 1992: New charter of the central bank.
December 1992: Deposit insurance abolished.
1992-94: Basel capital requirements adopted, raised to 11.5 percent at December 1994.
1994-95: Provisioning requirements tightened.
April 1995: Limited, fully funded, deposit insurance, $20,000 (subsequently $30,000).
August 1995: Liquidity requirements system (raised to 20 percent of deposits through 1997).
September 1996: Market risk capital requirements.
1997-98: BASIC introduced (B for Bonds, C for Credit Rating, etc.).
March 1999: Capital requirements for interest rate risk.

For example, capital requirement consists of basic 11.5 percent counterparty risk requirements with other requirements on top, plus additional requirements for market risk and interest rate risk, bringing the total requirement to some 15 percent of assets at risk.44 Banks maintain, on average, about 19 percent of capital to risk-weighted assets. An interesting research project currently under way is looking at how the information from the credit bureaus discussed above can be used to adapt counterparty capital requirements more closely to actual risks.45

Turning to the supervisory function, this task is performed following a scheme very similar to the CAMELS model, developed by the Office of the Comptroller of the Currency (OCC), under the U.S. Treasury, and the U.S. Federal Reserve Bank System. Supervision is performed on a consolidated basis, with periodic on-site inspections of banks.46

Using the information disclosed and validated by the external auditors, the BASIC system of banking oversight also includes techniques to enhance market monitoring and disciplining. These instruments are represented by the letters “B” and “C.”

The letter “B” makes reference to the obligation banks have to issue bonds or other long-term liabilities, to an amount equivalent to 2 percent of total deposits for each one-year period. To comply with this regulation, banks must go to the market, obtain ratings, and subject themselves to analysis by institutional investors (domestic and foreign) who put their capital at risk. The focus of this regulation, unlike the proposals currently in the United States, is on the primary market. The regulation applies to virtually all banks, but banks may comply through a fairly wide set of instruments. In other words, the decision was to allow banks flexibility to reduce costs at the expense of standardization. This implies that secondary markets are very thin and instruments among banks are not highly comparable such that secondary market yields are not highly informative for considering comparable market risk assessments. However, the process of going to the primary market each year enhances monitoring and discipline, and new groups of “sophisticated” agents interested in banks’ performance are generated.47

It is fair to comment, however, that the experience with this regulation has been mixed. The regulation was introduced in 1997 and was quickly followed by the Asian crisis, the Russian default, and then the devaluation of the Brazilian currency (real). Over this period, banks and other Argentine corporates found that issuing longer-term liabilities was either very expensive or simply impossible. The central bank responded by adjusting the regulation governing banks’ obligations to issue bonds (in particular, the exact annual deadlines to issue bonds was left to the banks) and reducing the penalties for noncompliance. Calomiris and Powell (2001) present evidence that the way in which banks comply with this regulation gives information regarding banks’ strengths and suggest that, on the whole, this regulation has served a very useful purpose.

Finally, the letter “C” makes reference to the role played by the credit rating agencies in banking supervision in Argentina. The main objective of this regulation is to provide depositors, especially the “smaller” or less sophisticated depositor, with information regarding the risk of the bank in question, putting them in a better position to evaluate their investment. This regulation initially stated that each bank must have two credit ratings, drawn from among a group of authorized agencies. The list of authorized agencies included both some local agencies and well-known international names. In actuality, however, there were clear differences in the quality of the ratings and there was perhaps more information on the particular agencies chosen by banks rather than the ratings themselves. The regulation was subsequently changed to request that banks obtain only one rating but that the rating should be from an authorized international rating agency to ensure greater consistency. At the same time, some of the local agencies merged and/or were bought out by international ones, reflecting the general trend toward greater concentration in the rating industry.


The BASIC system represents a set of interlocking instruments related to banking oversight. This set of policies, developed after the “Tequila period,” sparked in the region by the 1994 devaluation of the Mexican peso and ensuing financial crisis, together with the liquidity policy highlighted above, has had a tremendous impact on the financial system. Moreover, these policies have been complemented by the entrance of foreign capital. In the pre-Tequila period, the banking sector, unlike elsewhere in the economy, received virtually no new injections of foreign capital. In 1996-97, however, this situation was reversed to bring the banking sector more in line with many other economic sectors.

As of December 1997, foreign capital as a percentage of the total net worth of private banks had reached 55 percent and the deposits of those institutions with at least 30 percent of foreign capital accounted for 43 percent of the total financial system (i.e., including the public banks) and almost 60 percent of deposits in the private banks. The internationalization of the financial system has played a very important role in these last few years in contributing to economic and financial stability in Argentina.

Clearly, such a tight liquidity and regulatory regime has its direct costs. The increased safety has led to increased size, foreign entry, and hence new technologies however, and has intensified competition in the sector. This has provoked significant net efficiency gains in the industry. Thus, implementing this strong regulatory regime has implied lower (not higher) administrative costs as a percentage of assets and a reduced (not higher) cost of credit, and it has made more credit available throughout the economy.

Some argue that the strength of banking sector regulations should depend in some way on the exchange rate system in place—for example, that a fixed exchange rate system requires stronger banking sector regulations. The above arguments suggest advantages to strong banking sector regulations irrespective of the exchange rate system in place. In my view, it is entirely incorrect to suggest strong banking regulations solely for countries with fixed exchange rates. An analogy might be that it is like recommending wearing seat belts only to those with no airbags in their cars. Even if you have an airbag, not wearing a seat belt might cost you your life. Moreover, the ability to suffer a dramatic exchange rate depreciation (due to the injection of domestic liquidity in the banking system at a time when there was no demand for domestic assets) has considerably more associated costs than inflating an airbag!


In this paper, I have considered three central policy areas: (1) exchange rate regimes; (2) liquidity policies; and (3) banking sector regulations, albeit in a somewhat subjective and selective manner. The main conclusions of this paper might be summarized as follows.

  • First, exchange rate management remains as controversial as ever. One way forward would be for the world community to acknowledge explicitly that the choice of exchange rate regime is for the country but to determine clear key guidelines or even standards to accompany different exchange rate policies. A country that wishes to maintain a fixed exchange rate and an open capital account should be advised to adopt a currency board type mechanism and countries with capital account restrictions should develop mechanisms of communication to ensure that the market perceives overall policy consistency. On the other hand, a country that wishes to adopt a floating exchange rate with an open capital account will wish to develop hedging instruments as far as is feasibly possible and such countries with significant currency mismatches will need to consider how they will react to potentially volatile exchange rate swings and strong balance sheet effects. If such swings are too volatile, there may be a case for maintaining capital market restrictions (if considered workable), although costs should be weighed against benefits. Countries that wish to follow an intermediate path will in general need to maintain some measure of capital import taxes or other controls and, naturally, the benefit of the increased “flexibility” in terms of exchange rate/monetary management must be weighed against the cost of less access to international capital. Again, the importance of countries ensuring that the market perceives overall policy consistency is paramount.
  • Second, emerging countries face a tighter trade-off between monetary and financial stability and, in keeping with a safety-first approach, may need to consider establishing a systemic liquidity policy as a way of enhancing this trade-off—irrespective of the exchange rate regime in place. This liquidity policy should take into account the public sector and the banking sector and possibly also the nonfinancial private sector. Official data recently made available represents a considerable advance in monitoring countries’ liquidity positions but, in my view, suffers from serious deficiencies that produce misleading conclusions for some countries, including Argentina. No doubt, definitions will be improved over time to remedy these problems. A systemic liquidity policy has its direct costs and one way of thinking about the role of the IMF and multilateral development banks is to complement such a national policy. In practice, these institutions are actually playing this role but it would be helpful to elucidate a set of principles to define more clearly the respective role of these institutions in this important task.
  • Finally, there has been a great deal said and written about building a safe and sound banking system. Traditional regulation and supervision, on one hand, and the market, on the other, are complementary mechanisms and should be developed in tandem. They may be complementary both in terms of monitoring and in terms of discipline. This is precisely the thinking behind Argentina’s BASIC system for banking oversight, which has yielded significant improvements for the banking sector. There is no trade-off between banking sector soundness and the exchange rate regime in place.

In many areas, the discussion above has simply raised issues or presented a first attempt at various ideas. It is hoped that at least this the paper will generate discussion on the appropriate safety-first policy combinations that emerging countries may wish to consider, how data regarding those policies should be defined and disseminated, and the role of the multilaterals in complementing those safety-first strategies.

Table 9.A1Exchange Rate Regime Classification

(July 1995 and December 1999)

Exchange Rate Regimes 1995 (Number of Countries = 181)

Exchange arrangements with no separate legal tender
CFA franc zoneAnother

Currency boardEuro areaECCMWAEMUCAEMC
1Argentina7Austria18Antigua and Barbuda24Benin32Cameroon38Kiribati
2Brunei Darussalam8Belgium25Burkina Faso33Central African Republic39Marshall
3Hong Kong SAR9Finland19Dominica26ComorosIslands
4Djibouti10France20Grenada27Côte d’Ivoire34Congo, Republic of40Micronesia
5Estonia11Germany21St. Kitts and Nevis28Mali35Chad41Panama
6Lithuania12Ireland29Niger36Equatorial Guinea42San Marino
13Italy22St. Lucia30Senegal37Gabon
14Luxembourg23St. Vincent and the Grenadines31Togo


1Bahamas, The1Afghanistan58Angola
9Cape Verde9Cost Rica66Dominican

10Cyprus10El Salvador
11Czech Republic12Gambia, The67Egypt
20Kuwait21Japan76Lao, PDR
23Libya24Kyrgyz Republic79Malaysia
30Nicaragua32New Zealand86Slovenia
31Nigeria33Norway87Sri Lanka
32Oman34Papua New Guinea88Sudan
34Samoa Occ.36Peru90Turkey
35Saudi Arabia37Philippines91Uruguay
37Slovak Republic40São Tomé and Principe
38Solomon Islands41Sierra Leone
40Syrian Arab Republic43South Africa
44United Arab Emirates47Tajikistan
46Venezuela49Trinidad and Tobago
47Yemen, Republic of50Ukraine
52United Kingdom
53United States

(July 1995 and December 1999)

Exchange Rate Regimes 1995 (Number of Countries = 185)

Exchange arrangements with no separate legal tender
CFA franc zoneAnother

Currency boardEuro areaECCMWAEMUCAEMC
1Argentina9Austria20Antigua and Barbuda26Benin35Cameroon41Kiribati
2Bosnia and Herzegovina10Belgium27Burkina Faso36Central African Republic42Marshall Islands
3Brunei Darussalam12France22Grenada29Côte d’Ivoire37Congo, Republic of44Palau
13Germany23St. Kitts and Nevis30Guinea-Bissau45Panama
4Bulgaria14Ireland31Mali38Chad46San Marino
5Djibouti15Italy24St. Lucia32Niger39Equatorial Guinea
6Estonia16Luxembourg25St. Vincent and the Grenadines33Senegal
7Hong Kong SAR17Netherlands34Togo40Gabon
Other conventional

fixed pegged



Exchange rates

with crawling bands

Managed floating

with no preannounced

path for exchange rate
2Bahamas, The46Denmark52Costa Rica57Hungry2Albania52Azerbaijan
5Barbados49Libya55Turkey60Sri Lanka5Australia55Cambodia
7Bhutan62Venezuela7Canada57Czech Republic
8Botswana8Colombia58Dominican Republic
9Cape Verde9Congo, Democratic Rep.
12El Salvador12Eritrea61Jamaica
13Fiji13Gambia, The62Kenya
14Iran14Georgia63Kyrgyz Republic
15Iraq15Ghana64Lao PDR
21Macedonia, FYR21Japan70Romania
23Maldives23Korea72Slovak Republic
29Netherlands Antilles30Mozambique
30Oman31New Zealand
31Pakistan32Papua New Guinea
34Saudi Arabia35Russia
36Solomon Island37São Tomé and Príncipe
37Swaziland38Sierra Leone
38Syrian Arab Republic39Somalia
39Tonga40South Africa
40Trinidad and

42United Arab Emirates45Thailand
44Zimbabwe47United Kingdom
48United States
49Yemen, Republic of

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The multilateral development banks are the World Bank and the regional development banks.


See Mundell (1961), McKinnon (1963), and Mundell (1969). The second part of this last publication discusses problems in the international monetary system toward the end of the Bretton Woods system of fixed rates.


For example, the Plaza Accord of September 1985, under which the United States, United Kingdom, France, Germany, and Japan agreed exchange rate targets, and the Louvre Accord of February 1987, involving the same G-5 countries, plus Canada.


In the next section, I discuss the tension between monetary and financial stability and ways to break (i.e., improve) the trade-off.


The author remembers one U.S. official noting that the U.S. intervention to stem the fall of the yen was considered highly successful and changed the course of the dollar/yen rate for at least a couple of hours! Mexican officials have stated on many occasions that they did not choose to float in December 1994, but were forced to do so as they effectively ran out of reserves.


Of course the euro floats against other non-member currencies—here, I am referring to the total fix of the minor European currencies against the euro “basket.”


G-22 (1998a), see p. 13, where the discussion on fixed rates appears to highlight the weaknesses—e.g., “… a sustainable commitment to a relatively rigid exchange rate requires a corresponding commitment to strong monetary and fiscal policies and an appropriate arrangement for regulating financial institutions. In a rigid exchange rate regime, a decline in demand for domestic financial instruments can bring a country’s hard currency reserves under pressure” whereas on floating rates it appears to highlight the benefits: “… flexible rates explicitly introduce two-way risk, and consequently, can help prevent the accumulation of excessive foreign currency liquidity mismatches and unhedged currency exposure. Flexible exchange rate regimes can also allow for greater macroeconomic policy flexibility than do more rigid exchange rate regimes ….” Mussa and others (2000) also stress the “corner solution” but in a similar vein to the G-22 (1998a), the tone appears to favor the floating end of the spectrum. Thus, they state in section three’s concluding remarks, “First, for most emerging market countries, primarily in Asia and Latin America (but also South Africa and some countries in Eastern Europe), floating exchange rate regimes appear to be the increasingly relevant choice.”


The experience of the United Kingdom deserves significant attention. On the one hand, the system has been highlighted as a model in terms of the design of the regime and its transparency and yet, on the other hand, the United Kingdom has suffered significant exchange rate volatility. U.K. central bank governor Eddie George is reported to have stated to a Treasury select committee that the pound was “grossly” or “enormously” overvalued against the euro. Susil Wadwhani (a member of the U.K.’s Monetary Policy Committee) apparently likened the foreign exchange market to a “herd of cows” and in defence of intervention suggested that it could act akin to some dogs that might be able to “steer a few cows in a particular direction.” Both quotes come from “Central Bank ‘would act’ on strong pound,” Financial Times (New York edition) May 24, 2000, p. 11, by Ed Crooks, economic editor. In contrast, on the whole, the Chilean peso has suffered surprisingly little volatility considering the size of shocks received—I discuss below interpretations of low volatility in emerging exchange rates.


See for example Calvo (2000) for arguments and analytics in this vein.


In this group, I would include for example Robert Barro, Guillermo Calvo, Richard Cooper, and Ricardo Hausmann.


See for example Calvo and Reinhart (2000), and Hausmann, Panizza, and Stein (2000). Interestingly, in Mussa and others (2000), the authors appear to chastise emerging country floaters for not letting exchange rates float enough, expounding the theory that an exchange rate with some volatility will lead to greater incentives to hedge and, hence, if there is then a wild exchange rate move as more agents will be hedged, this will be less costly. However, pursuing the arguments of Hausmann and others, the lack of hedging may be only partly related to the lack of demand but may be also very much related to a lack of supply of hedging possibilities. The counter argument is then that, given the substantially higher cost for emerging countries to issue debt in domestic currency (see next section), it is likely such systemic foreign exchange hedging will also be highly costly if feasible at all at any significant maturity.


See, for example, Ghosh, Guide, Ostry, and Wolf (1997), Quirk (1994), and Levy Yeyati and Sturzenegger (2001). In the last paper the authors find, using a de facto rather than a de jure exchange rate classification, that countries with de facto fixed exchange rates tend to trail floaters in terms of growth.


These classifications are aggregated into: 1. Fixed: no separate legal tender or currency board; 2. Intermediate: other pegged, pegged within bands, crawling pegs, or crawling bands; and 3. Floating: managed float and independent float.


The recent case of Argentina may perhaps suggest to some that currency boards should be avoided. However, it was in my view again a case of the supporting policies—in particular, fiscal, price and labour market flexibility—not being consistent with the fixed exchange rate arrangement.


See recent statements by Ernst Welteke, Bundesbank president, that the markets have an erroneous impression of the fundamental improvements in euroland and that, “the herd-like behavior of markets can lead to a situation in which market values move away from fundamental data for a certain period … This is more than obvious at the moment in the case of the euro’s external exchange rate,” quoted in “Frail euro blamed on ‘herd-like’ markets,” Financial Times (London), May 23, 2000, p. 3.


The arguments presented are close to those in the recent Financial Stability Forum (2000) and the discussion on liquidity risks in the G-22 (1998b). However, I go further in attempting to define why a systemic liquidity policy might be required and the possible components of such a policy.


As banks normally have an asset-liability maturity mismatch, rising interest rates will lead to lower banking solvency (e.g., the U.S. savings and loans crisis of the 1980s).


See for example, Demirgüç-Kunt and Huizinga (1999) and other papers in the World Bank’s research project on deposit insurance design.


The facility was triggered in August 2001 in conjunction with an IMF package to support the banking system. The private sector creditors were subsequently fully repaid. The $1 billion official enhancement is subject to a different amortization schedule.


In fact, the currency board law allows this backing to be reduced to two-thirds. If these “excess reserves” above the legal backing are then also included in the calculation, the central bank could inject about 38 percent of the deposit base in hard currency liquidity. It is therefore somewhat ironic to hear it often repeated that Argentina has no lender of last resort to its banking system due to the currency board system!


Of course, this calculation assumes that the liquidity requirements are binding. If they are not binding, then the costs fall to zero.


As mentioned, the Contingent Repo Facility has an enhancement from the World Bank and the IDB. The appropriate role for these institutions is discussed further below.


Subsequently much of the liquidity armour of the central bank was indeed used, including reductions in liquidity requirements, liqudiity assistance using “excess reserves,” and the use of the contingent liquidity facility. While the use of this liquidity gave Argentina a little more time, unfortunately that time did not result in a solution to Argentina’s much deeper problems. The conclusion is that liquidity protection can be helpful but is obviously no solution to more deeply rooted problems.


To the extent that a country manages to maintain some domestic investors as “captive,” then this trade-off might be ameliorated. I discuss this further below.


See the discussion of liquidity, currency and interest rate risk in the G-22 (1998b). The argument is also closely related to the idea of “original sin;” see Eichengreen and Hausmann (1999).


Some have interpreted the rule as applying to only short-term external debts. The “Guidotti rule” referred to all (i.e., internal and external, short and long term) public sector debt coming due within a 12-month period.


Financial Stability Forum (2000) shied away from recommending controls or appropriate liquidity protection favoring only the monitoring of nonfinancial, private sector external liquidity positions.


See Le Fort (1998) and Gallego, Schmidt-Hebbel, and Hernández (1999) for further details and discussion.


Deposit statistics are taken from the IMF’s International Financial Statistics. Obviously, 20 percent is a purely arbitrary figure adopted in sympathy with the ratio for Argentine liquidity requirements. Readers who prefer a different ratio are free to compare the reserve figures with their own fraction of deposits.


And also the currency. A domestic currency loan from a BIS reporting bank in an emerging country funded by local deposits does not count as “cross-border.”.


As stated in the BIS stock figures, the diligent analyst can control for this effect by comparing the consolidated with the nonconsolidated figures. However, this does appear to require a fairly high degree of knowledge regarding the data sources and definitions and, unfortunately, several analysts have not invested sufficient time or effort and have focused only on what they regard as “headline” (i.e., consolidated) liability figures with the predictable misleading results.


Here, I also include M0 in sympathy with currency board countries. Any reader in disagreement with this can simply subtract the 2 percent of GDP from the final figure.


Liquidity can be held in other forms apart from reserves and one possibility is contingent lines from the private sector (as Argentina and other countries have negotiated). However, it seems unlikely that such lines could be for much more than say 2 percent of GDP.


See Fischer (1999), Jeanne (2000), and Gavin and Powell (1997, 1998) on the lender of last resort role of the IMF.


As noted, this is only presented out of curiosity. The actual policy of the central bank is to cover MO and a percentage of deposits. The treasury manages the liquidity risks inherent in any debt outstanding.


Since this enhancement is to be used to finance “variation margin” payments if the contingent facility is drawn, it is not included in the figures presented above.


See, for example, G-22 (1998a). The following statement by Larry Summers (Council of the Americas, March 20, 2000) on the role of the multilateral development banks (MDBs) goes into more detail. Summers’ suggests an emphasis on three types of circumstances for their operations, the second being, “where the involvement of the MDBs can attract genuinely additional private flows: for example, where MDB co-financing arrangements and guarantees can enhance the credibility of developing country borrowers in the eyes of investors. In this context, we believe that the MDBs should continue to explore more innovative ways of catalyzing private capital flows to such countries, where these can be pursued within strict and clear guidelines that safeguard the financial position of the institutions.”.


G-22 (1998b) is a comprehensive “official” document on the issue. The Basel Core Principles (available at and the compendium of standards available on the Financial Stability Forum website (at are also required reading. Moreover, there is a very wide literature including extensive documents from the IMF and the World Bank.


See Powell (1998) for an overview. In that document, I discuss the two levels of complementarity, monitoring, and disciplining, and suggest a (very informal) “production function” for banking oversight.


The Vice Superintendent and the Superintendent are both members of the ten-person central bank board, which governs the entire central bank.


Calomiris and Powell (2000).


Market risk regulations follow an adapted Basel “standardized approach,” with higher risk weights (calculated as a function of the volatility of Argentine asset prices and using coefficients derived from a VAR type model) and less generous offsetting rules (to reflect lower price covariance). Interest rate risk applies to all banks (not just outliers) reflecting banks’ asset and liability mismatches and Argentine interest rate volatility again in a VAR type framework.


See Falkenheim and Powell (1999) for a non-parametric model of portfolio credit risk calibrated using the Argentine data. Within the central bank we have also adapted Creditrisk+ (trademark of Credit Swiss Financial Products, CSFP) and are now in a position to analyze the credit risk portfolio of any bank in the system using this parametric model.


The central bank has also developed an early warning system for bank failures. See Anastasi, Burdisso, Grubisic, and Lencioni (1999), “Predicting Bank Failures in Argentina,” available on the central bank’s website.


See Calomiris and Powell (2000) for a more detailed discussion of this regulation.

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