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Capital
controls needed to manage crises GENEVA: An intellectual basis for instituting capital and exchange controls in developing countries that have liberalized both, and maintaining them where such controls are in place, is provided in UNCTAD's Trade and Development Report 1998 (TDR). While these views would once have been dismissed as unsound and heterodox, the failure to reverse the Asian crisis, its spread to Russia and other regions, and Malaysia's action to institute such controls to promote recovery, have led to their being increasingly favoured by mainstream economists, and even the IMF and other citadels of orthodoxy, though this is sought to be qualified by the power to sanction and lift such controls being vested in the IMF. Dealing with the management of financial crises, the TDR notes that the East Asian experience has laid bare certain weaknesses in the international approach to the management of crises involving the sudden withdrawal of foreign capital and massive and sustained attacks on the currency. As a result of this approach, what appeared to be a liquidity crisis has been translated into a solvency crisis, through a collapse of currencies and asset prices. This process hurts not only those with external liabilities but also the economy as a whole, owing to its effects on output and employment. Lines of defence There are four possible lines of defence against an attack on the currency: domestic policies, primarily monetary policy; maintaining a sufficiently high level of precautionary foreign reserves and credit lines; recourse to an international lender of last resort; and imposition of a debt standstill and exchange restrictions, accompanied by initiation of negotiations for a rapid debt workout. While under normal conditions, interest rate differentials and monetary policy can alter the incentives for capital flows, as events in East Asia have shown, under conditions of panic, the effects of monetary tightening can be quite different: interest rate hikes may simply point to declining creditworthiness and greater default risk. Intensified difficulties among debtors can eventually lead to exchange-rate stabilization owing to the resulting squeeze on sales of the domestic currency, but at the expense of depressing the economy rather than through bringing back foreign capital. Maintenance of precautionary reserves or credit lines in amounts adequate to meet outflows during a currency attack poses problems of cost and feasibility. Accumulating reserves for sterilizing some of the capital inflow, involves purchasing them with the proceeds of domestically issued debt. It entails two sorts of costs: the cost to the economy as a whole, since the rate of interest on foreign loans usually exceeds the return on foreign reserves; and a cost to the public sector, since the real interest on government debt typically also exceeds the return on reserves. Alternative approaches might be to cover the short-term external liabilities of the private sector by long-term public borrowing matched by short-term investment abroad, or to arrange a private lender of last resort. But the borrowing or credit lines could be very large, especially if allowance is made also for withdrawals by non-residents from stocks and bonds. Moreover, a country may not have access to such borrowing or credit lines, and there is no assurance that monies under credit lines would be available as needed. Besides, net costs in both cases could be substantial. On the international response, the TDR notes that financial assistance coordinated by the IMF in recent years has usually come only after the collapse of the currency, and has taken the form of bailouts designed to meet the demands of creditors and to prevent defaults. Such operations have a number of drawbacks: they protect creditors from bearing the costs of their decisions, thus shifting the entire burden to debtors and creating moral hazard for creditors; and by securing ex-post public guarantees for private debt, they reduce perceived default risks. And more importantly, the sums required have been increasing and are reaching the limits of political acceptability in the countries providing them. This is also one of the main impediments to the establishment of a genuine lender-of-last-resort facility which would stabilize currency markets and thus avoid the transformation of currency attacks into solvency crises. In the absence of timely provision of adequate liquidity to counter attacks on a currency, a liquidity crisis will eventually lead to widespread defaults and bankruptcies, the TDR notes. Standstill principles The most effective way to prevent such an outcome would be through the extension and application of insolvency principles such as those in Chapter 11 of the US bankruptcy code. Based on the premise that the value of a firm as a going concern exceeds that of its assets in the event of liquidation, those principles are designed to address financial restructuring rather than liquidation. The procedures allow for a standstill on debt servicing in order to provide the debtor (who is left in possession) with breathing space from its creditors, and so prevent a "grab race" for assets that is likely to be detrimental not only to the debtor but also to unprotected creditors. The debtor thus has an opportunity to formulate a debt reorganization plan, and equal treatment for creditors is also guaranteed. During the reorganization, the debtor is provided with access to the working capital needed for its operations, by granting a seniority status to the new debt contracted. Reorganization is followed by resolution, and insolvency procedures may accelerate the process by discouraging holding-out by particular classes of creditors. The application of such principles to international debtors was raised in TDR 1986 during the sovereign debt crisis. The increasingly private character of external debt in developing countries has not only increased the likelihood of harmful debt runs and asset-grab races by creditors - and investors - but has also given greater pertinence to these bankruptcy principles in the management and resolution of international debt crises. However, a full-fledged international "Chapter 11" is neither practical nor necessary. Article VIII of the Articles of Agreement of the IMF may provide a statutory basis for the application of debt standstills through the imposition of exchange controls if a currency comes under attack, and it can be combined with the existing practices for restructuring debt through negotiations. And while standstills could be sanctioned by the IMF, a conflict of interest might arise since the countries that would be affected by its decisions are also its shareholders and the Fund itself is often a creditor. "It may be desirable to place standstill authority with an independent panel whose rulings would have legal force in national courts. A standstill could be decided unilaterally by the debtor country facing an attack on its currency, once its reserves or currency fall below a certain threshold, and then be submitted for approval to the panel within a specified period. Such a procedure would help to avoid a panic, and be similar to GATT safeguard provisions allowing countries to take emergency actions. "During the standstill and the subsequent negotiation of a debt reorganization debtor-in-possession financing could be provided by IMF 'lending into arrears', which would require much smaller sums than bailout operations." Such procedures would meet the need, once again evident in the East Asian crisis, to safeguard debtor countries from the over-reaction of financial markets. In the words of the New York Court of Appeals, which had once ruled in favour of a debtor government that had imposed a unilateral standstill, this would be "in entire harmony with the spirit of bankruptcy laws, the binding force of which ... is recognized by all civilized nations." [The court ruling over a Costa Rican standstill was later reversed at the instance of the State Department, which insisted on an IMF route to protect its own creditors, and presented it as the US state policy.] Inadequate and inappropriate measures On the issue of preventing future crisis, the TDR notes that a number of proposals have been made for measures to be taken at global, national and regional levels. However, global initiatives regarding the international financial system have not gone to the root of the problem. On the contrary, some such initiatives could reduce the autonomy and flexibility of national policymakers in introducing measures needed to protect their economies from volatile and speculative capital flows, it says. With greater integration of financial markets and increased scope for contagion, the international surveillance of national policies has gained added importance in ensuring the stability of the international monetary and financial system. However, it has so far been unsuccessful in preventing international financial crises and currency turmoil; nor is it clear that recently proposed improvements will lead to more effective implementation. Major financial crises are typically connected to large shifts in macroeconomic conditions external to countries where the crisis originated. External factors are as important as domestic ones in triggering both capital inflows and capital outflows. However, existing modalities do not address the problems of policy surveillance due to unidirectional impulses from changes in the monetary policies of the US and a few other OECD countries which exert a strong influence on capital movements and exchange rates. There are no mechanisms under the existing system of global economic governance for dispute settlement or redress regarding these impulses. The focus of attention of the proposed improvements in surveillance continues to be the role of domestic policies in generating financial fragility and crisis. However, even in this more limited area, the record has been mixed, in large part because of the tendency to ignore that markets can go wrong. While improvements in the timeliness and quality of information concerning key macroeconomic and financial variables are essential for effective surveillance, emphasis on the inadequacy of information as the major reason for the failure to forecast the East Asian crisis appears misplaced or exaggerated. Although the crisis has pointed to certain weaknesses in available information, these did not play an essential role. Rather, there was inadequate evaluation of the implications of the available data, including those in the periodic reports of the Bank for International Settlements (BIS), for countries' ability to continue to obtain funding from international financial markets. Similarly, the contribution to the East Asian crisis of weaknesses in domestic financial regulation and supervision has led to increased attention being focused on reform in this area. However, while such reform can reduce the likelihood of financial crises, experience indicates that, owing to the vulnerability of the financial sector to changes in economic conditions and to unavoidable imperfections in the regulatory process itself, even a state-of-the-art system of financial regulation does not provide fail-safe crisis prevention. There are serious weaknesses in the regulatory framework for the cross-border lending and investment at the source of such flows. They have been an important cause of the shifting of a disproportionate share of the cost of resulting crises onto debtors. A number of proposals have been made for new rules and institutions directed at exerting tighter control over international lenders and investors. While some could be adopted without major changes in existing institutions and policy regimes, others would require, to varying degrees, new and far-reaching international agreements, which might be difficult to achieve owing to uncertainties with regard to their effectiveness or to the concentration of power which they would entail. Collaboration and consultation at the regional level are capable of contributing to the prevention of financial crises. Their potential role is particularly important with respect to the prevention of currency disorders and contagion effects. Initiatives in this area, which may involve monitoring mechanisms or more ambitious arrangements linked to the provision of mutual external financial support, can benefit from the long and wide-ranging experience of the European Union. Exchange rate policies and controls However, none of these proposals for crisis prevention is capable of eliminating the need for active national policies in respect of the balance of payments and external liabilities. In this respect, exchange rate policies and controls over capital movements merit particular attention, says the TDR. There is no reason to condemn managed-exchange-rate regimes and sacrifice currency stability in the interest of free capital mobility. The alternative of freely floating rates, combined with capital mobility, would undermine currency stability, with attendant consequences for trade, investment and growth. A currency board system, the TDR says, can eliminate problems of debt management due to currency mismatches, and has proved a useful vehicle in certain countries for halting hyperinflation. "But such systems do not insulate economies from instability of external origin, since the effects of capital inflows and outflows are transmitted to levels of economic activity and to goods and assets prices, and may include threats to banking stability." But managed-exchange-rate regimes are vulnerable to large accumulations of short-term external debt and to other potentially volatile capital inflows. Even if used flexibly, such regimes are likely to be sustainable only if accompanied by active management of external liabilities, which may often entail recourse to capital controls. Capital controls are a tried technique for dealing with unstable capital movements. The measures traditionally focused mainly on cross-border transactions of residents and non- residents. However, owing to deregulation and recent developments in banking technique, accounts and transactions denominated in foreign currencies are now often available to residents. Since they can affect macroeconomic variables such as the exchange rate in much the same way as cross-border transactions, they are also a legitimate target for controls. Post-war experience has been marked by frequent use of such controls in industrial countries, and they have also played an important role in policies adopted by several developing countries during recent years in response to large capital inflows. The extent of successful recourse to capital controls suggests that current initiatives aiming to restrict national freedom of action in this area are inappropriate. The probability of financial crises can be reduced by better macroeconomic fundamentals, effective prudential regulation and supervision of the financial system, and improved corporate governance. But these entail structural reforms with an unavoidably long time-scale: in industrial countries, decades were typically required to complete such reforms and to build the institutions needed. Moreover, such actions at national level will not provide fail-safe insulation against currency attacks, which also respond to conditions in international financial markets and in the countries of international lenders and investors. The harm inflicted by currency attacks could be contained by new arrangements for crisis management such as a proper international lender of last resort or a framework for debt standstills and workouts, but these too are powerless to prevent them from starting and causing damage. Thus, in the absence of global mechanisms for stabilizing capital flows, controls will remain an indispensable part of developing countries' armoury of measures for the purpose of protection against international financial instability, so that for the foreseeable future, flexibility regarding governments' options rather than the imposition of new constraints is required. (Third World Economics No. 193, 16-30 September 1998) Chakravarthi Raghavan is the Chief Editor of the South-North Development Monitor (SUNS)from which the above article first appeared.
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