May 11, 1998

FINANCE: MANAGING CRISIS REQUIRES MORE THAN TRANSPARENCY

Geneva, May (Chakravarthi Raghavan) -- Transparency and information have become the solution or slogans, depending on who advocates it, have come to the forefront of the discussions on the financial crisis that began last July in East Asia, without an end in sight.  

The crisis produced its crop of alibis, causes and solutions - with almost every player, private or public or international, blaming the others for lack of information, and the afflicted governments for their failures.  

As Mr. Yilmaz Akyuz, UNCTAD's chief macro-economist put it at the seminar on East Asian Financial Crisis on 1 May, the issue of transparency and information has received considerable attention after the crisis.  

But "there is considerable ambiguity (in the public debate) as to who should know what and for what purpose," he said. On one view markets should know more about what governments are doing so as to avoid errors in financial and investment decisions. On another view governments need to know more about what markets are doing in order to intervene effectively to prevent financial instability. Yet another view is that the IMF should know more about what both markets and governments are doing in order that the IMF may effectively carry out its Art.IV consultations, and "use its yellow cards" in a timely fashion to avert crisis.  

"It thus seems that everyone ought to know about everything." 

But from an increasingly active civil society, there is a demand for total transparency and accountability by the IMF on what exactly it is doing, for whom, and how. Is it to be allowed to bury its failings, without public scrutiny and accountability, while playing god with other peoples lives?  

In testimony in Washington, before a US Congressional Committee (against funding the IMF), Mr. Waldon Bello, professor at the University of Philippines and a Banghok-based NGO 'Focus-on-the-Global-South' pointed out in the last week of April that Thailand's financial crisis (caused by IMF/World Bank promoted liberalization of capital accounts and indiscriminate encouragement to domestic financial companies to borrow from foreign banks and lend to domestic real estate and other sectors) had been at least two years old before it finally got attention after the July devaluation of the baht. 

It cannot be said that until July 1997, either the IMF or the World Bank were worried about the possible consequences of the massive inflows of foreign capital (in the form of bank lending, portfolio investments etc). In fact they were holding out Thailand and its central bank as a model. It was not a case of lack of information, but one of being blindfolded by ideology, Bello said. 

Even now what civil society in Asia is surprised about, he added, is that, despite the lessons of indiscriminate capital liberalization, the IMF's basic solution to the financial crisis is for Asian countries to liberalise the capital account and financial sectors even more.  

"The solution," Bello said, "is not just transparency, as Fund officials are now fond of arguing, but greater government regulation of capital flows, such as placing limits on bank exposure to real estate or creating mechanisms to limit portfolio investment.. (That), is the crying need." 

In opposing funds for IMF sought by the management and the Clinton administration, Bello said, "the IMF is not so much restoring our economies to health as bailing out the big international creditors.

By not allowing the latter to face market penalties, the Fund is practising what many in Asia sarcastically term 'socialism for the global financial elite'.... "The Fund is being brazenly used by the Clinton administration as an instrument to promote the bilateral trade and investment objectives of the US, leading to the weakening of the legitimacy of the IMF as a multilateral institution and to a backlash that could hurt America's ties with the region." 

Akyuz, and later other experts at the UNCTAD seminar including Prof. Jan Kregel of the University of Bologna and Mr. Robert McCauley of the BIS, noted (on the lack of information issue) that in fact that as early as 1996, BIS reports had expressed concerns over the extent of exposure of BIS banks in the region.  

Prof. Gerald Helleiner, Economics Professor at University of Toronto and Research coordinator of the G-24 technical support program, said that financial markets, unlike those for goods and services, do not follow text-book maxims, and the participants respond to 'signals' in a herd-like and perverse fashion.  

A problem with the widespread calls for 'transparency', Akyuz told the UNCTAD seminar, is that market participants, governments and international financial institutions do not always pay attention to such information or draw practical conclusions from it. The BIS in 1996, had warned clearly about the exposure of BIS area banks in East Asia. "It is feared," Akyuz added, "too much and too frequently available information could lead to short-termism and greater instability." 

Available information, Helleiner said, is always subject to interpretation by market participants and interpretations can and do alter at short notice. Thus, asset markets can settle at multiple equilibrium points in consequence of participants' alternative interpretations of available information about the future. These markets are hence highly vulnerable to fluctuations in "animal spirits" and, as in the recent East Asian case, to self-fulfilling losses of confidence.

'Bubbles' in asset prices and crises are inherent in financial markets and "no amount of increased information, transparency or supervision can prevent recurrent 'runs', panics and crises in stock and bond markets, property markets or currency markets. "The best that policy-makers may be able to achieve is some reduction in their frequency and greater preparation for the modification of their consequences." 

While there is consensus on need for prudential regulations, and some of them can slow down build-up of financial fragility by restricting risks taken by financial institutions, and others can provide safeguards to contain damage, "prudential regulations are ot sufficient to prevent financial crisis," Akyuz said. "After all many industrial countries with effective prudential regulations of the banking system have experienced various episodes of financial crisis. Also, such regulations, do not deal with corporate borrowing abroad (a problem in East Asia)."  

The fact that the most recent financial crisis originated within private markets and was driven by private international capital flows, Helleiner said, "must not lead us to forget that crises will, at times, continue to originate in macroeconomic mismanagement as well." 

Public sector debt crises will recur. Nor does the world yet have a solid system for the prevention and management of these more 'traditional' crises either, not to speak of the continuing 'non-stop' debt crisis of the low-income countries on which the IPC initiative has yet to make much of an impact, Helleiner said.

On the view that the problems in Asia were due to 'corporate governance', Akyuz wondered whether it was possible to say that the American or German or Japanese type of corporate governance was less prone to financial instability. "Until recently, most people thought that German/Japanese type bank-based system is more stable. Now we are told otherwise." 

Other questions in crisis management, the UNCTAD's chief macro-economist said, included how investment funds could be regulated to reduce volatility, whether this was possible or they should simply put up with volatility of flows rather than keep them out of emerging markets?  

But there is a danger to this view, he said. 

"How sensible is it to regulate and squeeze everything else just in order to allow freedom for capital to move across borders and currencies? Do we want to suppress risk-taking? After all the essence of investment is risk-taking and a high degree of 'animal spirit' is associated with high risks. Why not try to reduce certain types of risks (currency risks) through selective measures rather than cut across the entire spectrum of risks and suppress animal spirit?". 

"It is now becoming increasingly clear," Akyuz said, "that without tight controls over capital flows, it would not be possible to prevent crisis even when macro-economic fundamentals are sound and effective prudential regulations are in place. When a crisis occurs, default is inevitable without an international bail-out operation. However, the latter poses the problems of moral hazard." 

Current collective wisdom, he added, "seems to be for a combination of all three evils -- some control, a little bailout and some burden shifting onto the creditors." 

"Can we really strike the right balance among the three to minimise likelihood of crisis and damage they effect," he asked. With increasingly private character of external debt in developing countries, there is now a stronger rationale for designing mechanisms for orderly debt workouts, which draw on internationally recognized principles for handling private-sector bankruptcies. Application of such principles would eliminate need for massive international bailout operations and lender-of-last-resort facilities."  

The main issues raised in the management of the recent crisis, Helleiner said, relate to the distribution of the burden of adjustment between residents of debtor and creditor nations; the appropriate domestic macro-economic policy and the distribution of burden of domestic adjustment in the crisis-stricken country; and the size and nature of the external financial support. 

The immediate crisis response, Helleiner noted, had been for application of austerity measures in borrowers and on residents of crisis-stricken countries. 

In East Asia this had brought about an enormous real, downward adjustment -- with the five most affected countries undergoing a 11% of GDP turnaround in current account balances.  

If the crisis was a matter of short-term liquidity difficulties and panic, timely provision of significant external credit would have overcome the need for such draconian adjustment measures. Rather than permitting external private creditors to "take off" by failing to roll-over short-term credits, the financial system should have encouraged or forced them to maintain previous exposures, he said. 

"Just as a bank should close its doors temporarily, during a liquidity crisis, to prevent further runs on the bank, external

creditors should be prevented from leaving precipitately, and thereby creating an unnecessary economic collapse. Instead of bailing them 'out', international financial institutions should have bailed these private creditors 'in'," Helleiner added.  

And if the problem was one of solvency in which there would be a problem of future debtor payments, the earlier creditors "take a hit" and begin initiation of a debt workout, the better. Official action would again be needed to stop creditors from each running for "a piece of action" immediately.  

"Such a balanced approach," Helleiner said, "implied that the IMF and other official institutions involved would be "encouraging a moratorium on external payments at a fairly early stage and will be lending into arrears.... Early and significant official measures to ensure equity and balance in the burden of adjustment to crisis can reduce both the real costs at present borne by crisis-stricken countries and real costs of financial crises to the entire global system." 

Whatever the degree of real restraint still required in a crisis-stricken country, after better balance between external creditors and debtor-country is achieved, there remain important policy objectives in the debtor country, Helleiner argued. 

A key objective should be protection of the most vulnerable to domestic macro-economic restraint - the poorest and those most affected by cutbacks. This could involve reordering of the government budget, increased tax revenue to finance necessary expenditure or a degree of fiscal loosening, though the latter is not the only way to finance officially-provided safety nets. 

There is an important issue of appropriate fiscal-monetary policy mix. Current approaches involve sharp increases in interest rates to restore confidence in currency. In East Asia such rate rises have failed to restore confidence, rather they have been taken by investors as signal of extreme seriousness of underlying problems.  

"Confidence was certainly not furthered by declarations by the IMF and others that the problems of affected countries were deep and structural rather than of a short-term... Reasonable people may differ as to the details of the appropriate monetary and fiscal policy response to the crisis, but there is little doubt that monetary measures taken in the recent East Asian crisis failed in their primary intent." 

Other policy measures associated with IMF conditionality, Prof Helleiner said included: inappropriate issue linkages, timing of reforms and capital account policies.  

External sources of support, he said, should not intrude into policy spheres unrelated to the financial crisis, as has been done in South Korea and Indonesia. Longer-term development policy relating to the role of the State, governance questions, competition policy, openness to foreign direct investment and trade protectionism should not be conditions attached to external finance intended to address crisis situations, Helleiner said, referring in this connection to the forceful argument in this regard by Martin Feldstein in the 'Foreign Affairs'. 

Major structural reforms should, in any case, not be introduced at the height of a financial crisis. 

"Widespread bank closures, with only limited provision for depositor protection, constitute, at such a time, a major further blow to confidence. Most fundamental reforms take considerable time and should be introduced with due caution." As the Chief Economist of the World Bank, Joseph Stiglitz, has recently argued, "the worst time for the introduction of structural reforms in the financial sector is in the midst of a financial crisis." 

Helleiner was also critical of the push for capital account liberalization policies. "Since most now assign some responsibility for the crisis to premature financial liberalization and, in particular, liberalization of the external capital account, the conditioning of finance upon the further liberalization of the capital account is surely inappropriate. At the very least, it is extremely controversial! Most would describe it as foolhardy."  

Referring to the size and nature of external financial support needed, Helleiner said it was clear from the Mexican and East Asian experiences that "the size of the external financial inputs required for the resolution of financial crises in developing countries may be very large. It is far from obvious that the IMF will have the resources to supply the necessary amounts in the future. Even in these recent experiences, it was necessary to find a variety of other complementary sources of official finance." 

The manner in which such finance is to be supplied, is equally important. In order to address a liquidity crisis "it is necessary to insert liquidity, i.e. finance that is available at very short notice, in large amounts, and virtually unconditionally." 

"Finance supplied only on the basis of negotiated conditions and released only on the basis of compliance with them, through successive tranches, is not liquidity. It may be very helpful in the resolution of the crisis. In some circumstances, it may even be sufficient. But future liquidity crises will require a liquidity response." 

It was striking, Helleiner said, that the amounts quickly supplied to Mexico during its crisis far exceeded the amounts only slowly being made available to the East Asian countries in response to their crisis.

"Only about 20% of the financial package put together for East Asia has so far been disbursed," he pointed out. 

As for other issues that may arise in future crisis, deserving advance attention, Helleiner said one was how the system would respond to financial crises, including those originating within the private sector, in countries too small to constitute a threat to the international monetary and financial system? 

"Sharp reversals in private capital flows have already created havoc in some African countries ~ generating massive required turnarounds in the current account, just as large, relative to GDP, as those required in recent East Asian experience. There is no reason, on the face of it, why official support from the IMF and others should not be provided to 'less important' countries in the same way as it is provided to 'systemic threats' when they face identical difficulties. But no such agreements are yet in place. They need to be put in place."  

Another important question was that in times of financial crisis, there is likely to be a flight to large foreign financial institutions within the crisis-affected countries, whatever other directions the flight may take. 

"In these circumstances, the 'national treatment' required under the terms of the financial services agreement within the WTO may be quite inappropriate," Helleiner said. "It may be sensible and should be legitimate for the national authorities to devote particular attention to the problems of domestic financial institutions which are usually smaller and less internationalized. 

While there is some recognition of this potential problem in the WTO agreement on financial services, it is somewhat ambiguous in its formulation and will have to be tested through particular cases. It is important to prepare for such cases in advance," he said. 

In terms of crisis prevention and damage control, some important questions arise. 

Said Helleiner, in the aftermath of the East Asian crisis there has been greatly increased interest in the problem of volatile short-term private capital flows. Most discussion now revolved around the question of how to reduce surges in short-term capital flow rather than, as before, whether to. 

"The current debate about the appropriate international capital account regime for countries at different stages of financial development is a healthy one," he added. 

"It is important," the Research coordinator of the G-24 technical support program urged, "that developing countries develop a coherent response to the OECD push for across-the-board capital account liberalization ~ a push which is found within the IMF, as it discusses its new purposes and jurisdiction in the capital account; in the WTO, as it completes its negotiations on financial services and discusses the initiation of discussions on foreign direct investment; and in the OECD, as it continues its work on a multilateral agreement on investment. 

"Developing countries have yet to put together their own consistent and coherent approaches to capital account issues, and they need to do so as a matter of urgency. For the present, their emphasis on caution and order in capital account liberalization is entirely appropriate.  

"It will also be in everyone's interest if the turf struggles between the IMF, WTO and MAI can be quickly resolved," he added.  

Direct bilateral cooperation among central banks, Helleiner said, could be very helpful. 

"The degree of such cooperation among G-10 or BIS central bankers is much greater than that between any central bankers in the North and their counterparts in the South. How is it, that Northern financial authorities can be both so demanding and so cooperative with their Southern counterparts in the sphere of money laundering but not in the sphere of short-term capital flows?" 

It was clear that for financing of external crisis response, the resources of the IMF are quite inadequate to provide sufficient liquidity to address future financial crises of the East Asian kind. The IMF Managing Director has already appealed for a significant increase in IMF quotas, but to little effect. There is little prospect that developing countries can acquire sufficient reserves or access to sufficient credit lines to protect them adequately against future such crises. 

The IMF would therefore have to develop its role, less as a financier than as a 'leader' and 'signaller' for other sources of finance, notably central banks and the members of the BIS.  

"New forms of regional cooperation, such as were mooted in response to the East Asian crisis but discouraged by the US and the IMF, should also be explored further," Helleiner said. 

Direct central bank cooperation through swap arrangements and similar devices will also have to be expanded. Again, if central banks can work so closely in cooperation against money laundering, it is difficult to see why they cannot act similarly in other spheres. 

The recent experiences underline most clearly that the IMF and the international community still suffer from lack of an independent evaluation and assessment unit at the Fund. The recent IMF experiment with external assessment of the Extended Structural adjustment Facility (for Africa) programme had uncovered significant differences of view between the IMF staff and external assessors. This illustrated the potential importance and value of such independent assessment, Hellein added, and drew atention to a recently released report by Jacques Polak and others, prepared for the Washington-based NGO, 'Center of Concern'.