Revolution of the international financial system is unnecessary; the present system has been instrumental in producing more prosperity for more people than ever before. Nevertheless, the presence of volatility and contagion in the system continues to cause problems. Writing in the latest issue of the Economic Journal, Professor Stanley Fischer (First Deputy Managing Director of the IMF) outlines a package of reforms that he believes will reduce both the size and frequency of future crises.
Professor Fischer begins by highlighting five key areas on which policies in emerging market countries should focus.
Sound Macroeconomic Policies: A central issue is the exchange rate regime that countries adopt. The major external crises of the last two years – Thailand, Korea, Indonesia, Russia and Brazil – have affected countries that have had a more or less fixed exchange rate in the period leading up to the crisis. These facts of recent history have pushed the balance in the long-running debate about exchange rate systems towards floating rates. Countries with open capital accounts that wish to fix their exchange rates should do so through a currency board.
Strengthening Domestic Banking: Aside from Brazil, a weak banking system has been at the centre of recent crises. Steps towards strengthening this system should include not only regulation and supervision, but also the acceptance of foreign competition.
Provision of Better Information: Better information on a country''s policies, on the state of the economy, and on individual firms, should make private financial markets more efficient and less prone to disruption. This should also lead to the pursuit of better policies; some of the policies responsible for the depth of recent crises would not have been undertaken had they been required to be made public.
Strengthening Corporate Finance and Bankruptcy Laws: The size of the Asian crises owes much to excessive leverage by Asian corporations. The adoption of appropriate auditing and accounting standards, principles of good corporate governance, and efficient bankruptcy proceedings (laws and the courts to enforce them) would all have gone some way to reducing the size of the crises.
Dealing with Reversals of Capital Flows: Countries with large reserves have generally been more successful at dealing with crises. A cheaper alternative to increasing the size of reserves is to establish precautionary lines of credit. In addition, market-based capital controls along Chilean lines, that moderate the pace of short-term outflows and inflows, may be useful. But if controls on capital are already in place, they should be removed gradually, as a country''s economy strengthens.
Reform is needed not only in emerging markets but also in the countries where the capital flows originate. In addition to maintaining low inflation and stable growth, these countries should pay particular attention to their banking systems. Regulators need to ensure that highly leveraged positions are both monitored and controlled, possibly through margin requirements or controls on off-balance-sheet activities. The spread of the Russian crisis owed much to the highly leveraged positions taken by G-7 institutions, such as LTCM.
The International Financial Institutions (IFIs) can also contribute to improving the operation of the
international financial system, Professor Fischer suggests:
By encouraging the implementation of international standards, the IFIs can strengthen both the financial system and economic policy. The IMF has begun an experiment of producing transparency reports, which describe the extent to which a country meets these various standards.
The IMF''s Special Data Dissemination Standard has been established to improve the provision of information to the markets and to the public in general. At present, 47 countries are subscribers to this and steps are underway to include information on forward commitments and external debt.
Strengthening the process of surveillance will help the diagnosis of potential crises and the prescription of suitable corrective policy. The inclusion of information on derivatives and external debts in the Bank for International Settlements data on international capital flows along with the increased frequency (from biannual to quarterly) of its publication is one measure already underway that will help to achieve this. In addition, the IMF has embarked on an 18 month pilot project, which will examine the feasibility of publishing individual country''s Article IV reports. These reports record the annual consultation between the IMF and member countries on the state of their economies.
There are potential improvements to be made in the lending practices of the IFIs. The IMF has introduced the Contingent Credit Line (CCL) in order to combat the contagion evident in recent crises. The CCL will establish lines of credit for countries that attempt to meet the international standards; which seek to put in place private credit lines; and whose external debt is well managed. The CCL will enable the IMF to use its finances in a preventative mode.
These reforms all relate to crisis prevention. But whatever steps are taken, crises will still occur. Therefore, the capacity of countries to deal with crises should be strengthened. Professor Fischer argues that because of the potential moral hazard problem brought about by official lending (that is, investors will exercise less caution than they should in the belief that the fund will always ensure they are repaid), the question of how to ''bail in'' the private sector in times of crisis is paramount. The answer is not simple. The more certain it is that the private sector will be ''bailed in'' in a compulsory way, the greater the incentive for creditors to run – this may tend to produce more rather than fewer crises. Hence, the current approach of seeking to ensure that private sector participation varies according to the circumstances of each case is the best available solution.
''Reforming the International Financial System'' by Stanley Fischer is published in the November 1999 issue of the Economic Journal. Professor Fischer is the First Deputy Managing Director of the International Monetary Fund.
