Little Progress In Global Financial Reform

A United Nations meeting in Jakarta recently heard a panel of experts criticising the lack of progress in instituting real reforms to the global financial system, despite the rhetoric by some world leaders about the need for a new ‘financial architecture’ during the Asian crisis a few years ago.

This was a major theme that emerged from a panel of experts speaking at the United Nations regional consultation meeting on Financing for Development held in Jakarta on 2-5 August.

The experts included Yilmaz Akyuz, UNCTAD’s chief economist, Ariel Buira, former Deputy Governor of Bank Mexico (Mexico’s central bank), and Aziz Ali Mohammed, Adviser to the Group of 24 (developing country group at the World Bank and International Monetary Fund).

They pointed out that despite the many discussions and venues on the ‘new international financial architecture’, little or no progress has been made since the recent round of financial crises, either to prevent or to better manage future crises.

The meeting, organised by ESCAP (the Economic and Social Commission for Asia and  the Pacific)  and  UNCTAD  (the  UN Conference on  Trade and Development) and hosted by Indonesia, is part of regional consultations to prepare for the United Nations high-level ‘event’ on Financing for Development to be held in 2001.

In the plenary session on ‘Recent developments in the reform of international financial architecture’, UNCTAD Secretary-General Rubens Ricupero (who chaired the session) posed some critical questions for discussion.

Among them: What is the state of debate on IMF reform? Is there a need for global financial standards and should it be on the basis of one-size-fits-all? Can financial regulation and supervision be organised under current arrangements or will an extension be needed and would it just add more conditionality?

Also, what is the scope of prudential regulations and how effective are they? Why is it so important to Washington institutions that countries keep open their capital account and currency convertibility (that is, allow freedom for movements of funds)?

Ricupero concluded it is difficult to have measures to prevent financial crises but also to institute national financial safety nets. Another problem is that any global system of controls must be able to accommodate diverse national conditions and also be compatible with regional arrangements.

A wide-ranging review and analysis of current developments in the debate on managing and preventing crises was presented by Akyuz, Officer-in-Charge of UNCTAD’s Division on Globalisation and Development Strategies.

Dealing first with prevention issues, Akyuz said that since the crisis, the reform discussion had placed more emphasis on greater information provision. However, having more information is not enough to prevent crises.

Moreover, although much has been done on getting more information from governments, there has been less work done on getting information on markets. Little has been done on highly leveraged institutions and offshore markets, although there has been discussion at the Financial Stability Forum.

Akyuz pointed out the uneven nature of the use of information. IMF surveillance had focused mainly on developing countries. So far the IMF consultations with countries had been unable to prevent major financial turmoil. It has been reluctant to advise countries to control short-term inflows before a crisis strikes.

On the other hand, said Akyuz, too little attention is being paid to policies of developed countries as they affect developing countries’ exchange rates. Every emerging-market crisis of the 1980s and 1990s was associated with major swings of exchange rates of major industrial countries.

A major issue is whether developing countries are capable of maintaining exchange-rate stability when major currencies undergo sharp fluctuations. Akyuz said currency coordination among the three major entities (the US, Europe and Japan) is needed for the stability of the euro, dollar and yen. But there has been no resolution of this.

As a result there are gyrations of up to 20% in the span of a week or 10 days. Although there are such very large swings, their effects on developing countries have simply been ignored and developing countries are expected to adjust to such changes.

On the issue of prudential regulation, Akyuz said the international approach is to formulate global standards and countries are expected to implement them individually. The standards are set in the Bank of International Settlements (BIS).

Akyuz said there are three problems with this procedure. Firstly, such standards do not account for risks in international lending. Although new proposals have been put forward to respond to this, they actually create new problems. For instance, the standards rely on external rating agencies, but they have a poor record, being pro-cyclical.

Secondly, the standards are designed to protect creditors, not the debtor countries. The same level of exposure may mean different risks to creditors and debtors.

Thirdly, there is a danger of a one-size-fits-all approach to standards. The IMF has now extended its survey of countries to include this issue. Although there is agreement that the IMF should not set standards, there is now a concern that it would police the implementation of such standards.

On managing capital flows, Akyuz said that after the latest crises, there appears to be agreement that short-term flows need to be regulated. Developing countries are not stopped from controlling their short-term capital flows. But the international approval of such measures would help countries planning to introduce these moves. So far such an approval has not been forthcoming.

On exchange rate regimes, Akyuz said the present advice to developing countries seems to be to either fix (through a Currency Board system or even dollarisation) or freely float their currency, and not to support it through an intermediate regime.

However, UNCTAD studies had shown that a float system is associated with the same degree of  volatility as  countries with  a  fixed system.  The difference between  the two is how the shocks work themselves out.

The main issue is that the choice of exchange rate regime should not be part of IMF conditionality and countries should choose their own system, added Akyuz.

On the management of crises, Akyuz highlighted two issues: provision of international liquidity (channelling foreign funds to countries facing a crisis) and orderly debt workout (having a fair and orderly deal between a debtor country facing debt-servicing problems and its creditors to restructure debt payments).

Countries facing crisis have three problems relating to international liquidity provision.

Firstly, multilateral institutions do not have funds. Although the IMF has introduced facilities, they lack funds. Thus, the IMF has to draw on its major shareholders, opening the road to undue political influence.

Secondly, the conditionality (or condition that the country has to follow policies set by the IMF) associated with such provision of liquidity is excessively intrusive. Even mainstream economists (such as Martin Feldstein of the US) have said the conditions interfere with the sovereignty of recipient countries.

Thirdly, the funds go not to the affected countries but instead to bail out creditors. The funds should ideally be used to support the country’s currency level against speculation, but in a typical case the currency is instead allowed to collapse and the funds go to bail out the creditors.

On the issue of orderly debt workout, Akyuz said UNCTAD had raised the issue that many debtor countries were treated as de facto bankrupt but were not afforded the protection of bankruptcy courts. In such a bankruptcy-court system, a debtor would have rights, including a temporary standstill on payments of its debts, continued financing for on-going operations, and an orderly debt restructuring.

Akyuz pointed out that Article 8 of the IMF’s Articles of Agreement allows for this temporary standstill. But in practice, as in the South Korean case, this does not take place. Instead, the creditors came together and met the government in a private meeting to strike an agreement.

But in such cases of restructuring, as took place in respect of South Korea’s debts, three problems arise: governments are asked to assume private debt; creditors get better terms  in  restructuring whilst  in a  bankruptcy court  (modelled after  Chapter 11  of  the US law) debtors get better terms; and the new finance goes to creditors instead of supporting the debtor.

Akyuz said Canada had proposed a six-point plan to introduce an IMF standstill mechanism for countries facing attack. Although several IMF members now support such a mechanism, others oppose it and thus it has not come into being.

He added that some of the concerns expressed earlier, before the Asian crisis, should be reviewed in light of the Malaysian experience. Part of Malaysia’s capital controls was a temporary standstill, and it is now widely accepted as a success. ‘We should examine that experience and see what lessons can be drawn from it for the temporary standstill mechanism.’

Ariel Buira, Mexico’s Ambassador to Greece and former Deputy Governor of Bank Mexico, said it is recognised today that all is not well with the global financial system. The role of the international financial institutions and the conventional wisdom of the Washington Consensus are both being questioned.

‘We have an international monetary system that is crisis-prone,’ he said, pointing to the currency crises in Europe (the crisis of the early 1990s in Italy, Spain, the UK and France), Mexico (1994-5), Asia (1997-8), Russia and Brazil.

‘Private capital flows can destabilise any economy by being too big or too little. We have failed to put reforms in place. We are not sure there won’t be a crisis in the coming months or years.’

Buira said there have been some changes in a somewhat reluctant fashion. Capital controls to avoid excessive inflows, that some countries have instituted, have become increasingly acceptable, with the IMF becoming a little more tolerant.

A report of the US Council of Foreign Relations had favoured this measure, and even US Treasury Secretary Larry Summers had said it may be useful in some cases.

Buira recounted how the IMF and US policy-makers had pushed for capital liberalisation (or the free movement of funds into and out of a country).

He said a New York Times article revealed how the then US Treasury Secretary Robert Rubin prevailed to persuade President Clinton to press the IMF to promote capital account liberalisation.

The article suggested there were strong interests in Wall Street pushing for capital account liberalisation. This had precipitated such liberalisation when the conditions to absorb it were not present.

On the issue of debt ‘bail-out’ and ‘bail-in’ of the private sector, Buira said that people who lend or invest in developing countries earn high premium because of the high risk.

He said in Mexico and other countries, the rescue packages had been aimed at rescuing creditors, who took no loss. They had obtained the high benefit of premia but did not face any loss (when the countries went into crisis). He added this was the real issue of ‘moral hazard’.

Buira suggested that in the reform process, the question is how to move from bailing out the private sector to bailing in the private sector.

He added that since the crisis had to do with capital flows, there were two choices in coping. The first was to provide unlimited support or huge amounts of funds to the affected country, which then would not run out of reserves (in supporting its currency) and this would thus discourage further speculation as the speculators would not be able to gain.

The second was for the country to stop or temporarily suspend payments to creditors in order  to  enable debt  restructuring.  To do this,  the private sector  had  to be ‘bailed in’.

In the exercise, no creditor or investor must run out in the next few weeks, payments for trade would continue but not debt-service payments, and there would be restructuring where everyone shares some of the costs. Thus, for example, instead of collecting in the next three years, creditors may be asked to collect in five or six years.

Buira pointed out there are some crucial issues where very little is being said in the reform discussion. There is no progress on IMF reform. There is also no progress on crisis prevention.

He said although there may be discussions on an early warning system and the need to bail in creditors, there is no development of rules. For instance, there is reluctance by some governments to determine when a debt standstill should be done, there are no rules for debt workout, and so far the IMF has not developed a facility to deal with preventing a crisis.

Buira added that other basic issues of interest to developing countries are not even on the table, for example the asymmetry in the adjustment process. By focusing on issues related to the Washington Consensus, the issues of developing countries are being neglected.

Among these neglected issues are: How can developing countries obtain benefits of globalisation whilst minimising the costs? What can be done to deal with reversal of capital flows, lender of last resort, and debt restructuring?

He said the IMF only comes in after a crisis has occurred, and this is inconsistent with the IMF’s stated objective of preventing crisis. The legitimacy of international financial institutions has come into question. There is awareness of a heavy concentration of power in a few countries and the need to have wider participation.

Aziz Ali Mohammed, Adviser to the Group of 24 (developing country members of the IMF and World Bank), gave a review of the state of the debate on the new international financial architecture (IFA).

He highlighted the imbalance in the process: the issues that have an impact on developed countries (requiring action on or by them) are not on the table whilst those issues affecting developing countries are.

He discussed four of the issues that should be on the table but are not.

First are the global implications of exchange rate movements of major currencies on which the IMF surveillance system had little to say despite the fact that they are sources of financial and economic disturbance to other countries.

Second is the unequal distribution of voting power in the global financial system, which derives from a totally arbitrary formula designed to perpetuate the dominance of developed countries.

Third is the internal governance of the IMF, in which a very few countries, and particularly the US Treasury, have an undue influence over the executive board and staff.

Fourth is the reluctance to apply the obligations of transparency, accountability and equity on the capital markets and institutions of developed countries.

Aziz stressed that the issue of equity must be put forward by the South in preparing its negotiations with the North in the context of the UN event on Financing for Development.

He said the global financial system is ‘full of asymmetries’. There is asymmetry (or imbalance) between borrowers on the one hand and creditors and investors on the other hand in the way they are treated; asymmetry in the governance of the international financial institutions; in the debt resolution process; and in the surveillance process in relation to major currencies as contrasted to developing countries’ currencies.

Aziz said that in taking up these concerns, developing countries must try to agree among themselves first, and highlighted five areas in which they need to develop positions.

First is the need to strike the correct balance between rules and discretion. On the one hand, we want to have rules (for example in the debt workout process) but rules also create risks for developing countries. A rule that enables temporary debt standstill can also increase risks of contagion. Would ‘constructive ambiguity’ be a better route on debt workouts?

Second is the question of who represents developing countries. Should their interests be promoted through treaty-based institutions like the Bretton Woods institutions, or should developing countries take part in ad hoc groupings?

Aziz said it was a strange situation when the United States decided to invite 11 developing countries to enter a Group of 20 (a new grouping established last year by the US to discuss financial issues) and those 11 jumped to take part, considering it a great privilege that they were chosen.

‘They lend themselves to a procedure that takes oxygen away from their own institution,’ said Aziz. He posed the question of whether developing countries should play this game, or stay on with representative institutions.

Third, on the development of regionalism, what importance do developing countries want to give to accepting peer pressure within regional arrangements?

‘Should our neighbours be enabled to engage in surveillance, or should the task be given to an institution located in Washington?’ he asked – SUNS4723

About the writer: Martin Khor is Director of the Third World Network.

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