Originally published in THE INTERNATIONAL ECONOMY
September/October 1999
NO NEW ARCHITECTURE
By Martin Feldstein
"If anything, the IMF should be refocused by giving it less money."
The outpouring of talk and writing about a new financial architecture reflects the consensus that the current system has failed. It failed to prevent the financial crises of the past two years, and it failed to stop the subsequent process of contagion and the ensuing painful economic declines. Even now, with recoveries under way -- increased GDP, rising stock markets, and stronger currencies -- we are still witnessing high unemployment, a trail of bankrupt small and medium sized businesses, and banking systems that are either insolvent, effectively nationalized, or both.
The adverse political consequences are no less important. Within emerging market countries, the crises have reduced support for capitalism and the economic and political arrangements that have brought strong growth and ethnic stability for more than thirty years. Internationally, the painful and demeaning nature of the crisis management has substantially damaged relations with the West. This is not often discussed since good relations with the IMF and key Western governments are needed to obtain continued funding and access to capital markets.
But despite the abundance of proposals for a new global financial superstructure, there have been no fundamental changes. There are many committees and many reports, but there is no new architecture.
And fortunately so. In my judgment, there is no need for a new global system. Instead, the traditional standards of sound practice in emerging market countries must be strengthened by the countries themselves and by their creditors, and the IMF must refocus itself on more modest and constructive goals.
Although the past policies of the emerging market continues deserve much blame for the crises, the IMF also deserves criticism for its failure to prevent the crises, for contributing to the contagion, and for mishandling the country programs. Any reform must begin by understanding the nature of these errors.
Fundamental Errors
The fundamental causes of the crises can be traced to three policy mistakes that, in varying degrees, characterized the crisis countries: (1) large current account deficits caused by overvalued exchange rates; (2) mismatched international balance sheets with short term liabilities which exceeded foreign exchange reserves: and (3) weak banking supervision that allowed banks to be de facto insolvent, which in turn caused runs on the banking systems and made foreigners reluctant to lend after the crises began. Thailand's experience illustrates all three problems: the fixed bhat-dollar exchange rate led to a current account deficit of 8 percent of GDP and encouraged Thai banks to borrow dollars abroad and lend them to Thai businesses. The current account deficit was unsustainable, and the resulting collapse of the bhat caused wide-spread bankruptcies among Thai businesses with large dollar liabilities. These bankruptcies left the Thai banks insolvent.
Going forward, the emerging market countries must reform these practices if they hope to avoid new crises.
No new external architecture can help them if they do not reform themselves:
Failure to make these changes will inevitably lead to future crises. But emerging market countries must also take responsibility for reducing the risk of unwarranted currency crises due to speculative runs and "contagion" effects. The key to protecting themselves against these latter risks lies with increasing international liquidity.
To increase their international liquidity, emerging market countries need to find ways to substantially increase their foreign exchange reserves at reasonable net costs by borrowing with long-maturities and investing the funds in higher yielding liquid assets. They can also increase international liquidity by developing back-up lines of credit with private creditors, as well as explicit market-based loan renewal and bond extension options.
Some experts have suggested taxing short-term credit inflows as a way of increasing net liquidity. The decision of whether to do so requires a delicate balancing of costs and advantages. Reducing short-term credit inflows raises the overall cost of foreign funds and may entail a reduction in the nation's rate of investment. The advantage of reducing potentially volatile short-term liabilities depends on how readily domestic bank deposits can and would be sent abroad in the same circumstances in which foreign short-term lenders would not renew their loans. Because these costs and advantages depend on individual national conditions, no general rule is possible.
None of these ideas would require or constitute in themselves a new architecture. These policies represent traditional good policies that emerging market countries should want to follow in their own self interest. Good risk management by Western creditor banks and by international bondholders would automatically reinforce the virtue of these policies if they are reflected in the cost and availability of credit. New IMF guidelines and enforcement policies are not necessary and run the risk of imposing one-size-fits-all standards where the market can more appropriately tailor policies to national conditions.
IMF Failures
This brings us back to the IMF and its failed policies. In my judgment, the IMF failed in three ways. First, before the onset of the crisis, the IMF failed to reduce both the risky behavior of emerging market countries and the high risk lending to those countries. They failed to convince emerging market countries through technical explanations and evidence from the experience of other countries that a continuation of current bad policies would inevitably lead to a painful currency crisis. They did not provide information to Western governments and central banks that might have allowed for more informed banking supervision and greater caution in credit availability. And they did not issue public warnings about the risk of certain types of emerging market policies which, even without naming individual countries, might have discouraged excessive risky lending by Western banks and bondholders.
The IMF also deserves criticism for its failure to prevent the crises, for contributing to the contagion, and for mishandling the country programs.
Second, when the crises occurred, the macroeconomic policies forced onto the crisis countries (sharply higher interest rates and increased tax rates) were wrong and made the crises worse. The combination of dollar-denominated corporate debt and high corporate leverage prevalent in these countries meant that the currency declines caused widespread bankruptcies and a massive deflation of demand. The additional deflationary policies required by the IMF only exacerbated an already bad macroeconomic situation.
Third, and more fundamentally, instead of trying to rebuild confidence and prevent contagion, the IMF declared that the East Asian countries were incompetent, corrupt, and incapable of functioning. It is not surprising that investors and lenders retreated and that the crisis spread to every country that shared the same appearance. The IMF failed to emphasize that the countries' common problem was illiquidity (a lack of foreign exchange) rather than insolvency (a long-run inability to repay outstanding debts through trade surpluses).
The Fund made matters worse by insisting -- as a condition for approval and financial help -- on radical reforms in every aspect of economic affairs, not only in macroeconomic and financial policies but also in labor rules, social policies, human rights, trade policies, and corporate governance. Insisting on these reforms in the midst of an economic crisis exacerbated the crisis itself, and some of the policies will destabilize and weaken the economies in the long run.
Regardless of whether these policies appear to be good or bad when judged by current economic thinking (a very imperfect and changing standard), they are not legitimate activities for the IMF. The IMF should focus on the macroeconomic and financial changes needed to bring the crisis countries back to a healthy relation with global capital markets, not on remaking the economy and society according to currently fashionable Western ideas.
The large loan packages that have been a central feature of all of IMF programs in recent years are a central part of the problem. On the surface, they look like the activity of a lender of last resort designed to stabilize the crisis. National central banks, in their proper role as lenders of last resort, prevent runs on illiquid but solvent banks by lending without limit at above-market rates on good-but-illiquid collateral. The IMF does nothing of the sort. The amount of lending can be large, but it is certainly not unlimited. It is done at below market interest rates and without collateral. Most significantly, it is disbursed slowly and unpredictably on the basis of complex conditionality rules, leaving other creditors unsure of the extent to which funds will be available.
The primary effect of the large subsidized loans is that they give the IMF the leverage over crisis countries to mandate far reaching changes. In order to raise large amounts of money for its loans, the IMF must design its conditionality policies in ways that appeal to the member governments that provide and guarantee IMF funding, no matter how irrelevant or counterproductive those conditions may be. In some instances, these funds do harm because they enable a continuation of bad policies -- as demonstrated in Russia.
Looking Ahead
Looking ahead, I believe that the activities of the IMF at the time of a crisis should be narrowed and refocused. It should act as an honest broker -- or a convener or a deal maker -- between debtors and creditors.
The IMF should limit its conditionality to the exchange rate regime, the external balance sheet, and the financial system. And it should not become involved with policies like labor rights, corporate governance, or trade barriers. The test of whether an IMF condition is appropriate should be, Is this change needed to get global lenders to lend again?
The key to refocusing the IMF is to give it less money. With less money at its disposal, it will not be able to provide the incentives to crisis countries to take on radical and irrelevant reform requirements. And because less money will be required of them, the major national legislatures that finance the IMF will not be able to exercise so much control over its policies.
The proposals and policies that have recently been adopted by the IMF to reduce the risk and pain of future crises are not likely to be any more successful. The IMF's Contingent Credit Lines (which would preapprove IMF credit for any country that has sound macroeconomic policies and a sound financial sector before a crisis ever hits) appears to be a way to reduce the risk of contagion and to soften the blow if a currency attack occurs. But would it work in practice? I believe not. It is worth noting that no country has applied for this preapproved status, every country knowing that it might be required to accept an IMF makeover in order to qualify or to remain in good standing. Indeed, once a country is approved, how could its approved status later be denied without triggering a run?
The recent IMF decision to expand its lending to countries that are in payment arrears to private borrowers is another counterproductive policy. While the policy is designed to force private lenders to be more willing to negotiate favorable terms during debt workouts, its primary impact may be to reduce the initial availability of credit while raising its cost. This may already be evident in a recent shift from debt capital to the more expensive equity funds.
The IMF declared that the East Asian countries were incompetent, corrupt, and incapable of functioning. It is not surprising that investors and lenders retreated and that the crisis spread to every country that shared the same appearance. The IMF failed to emphasize that the countries' common problem was illiquidity (a lack of foreign exchange) rather than insolvency (a long-run inability to repay outstanding debts through trade surpluses).
Similarly, the proposals to require mandatory bond and loan rollover provisions and majority voting clauses in bonds are also intended to make achieving workouts easier in times of crisis. If creditors and borrowers believe that these would be helpful, they could be written into bond agreements without pressure from the IMF. But mandating such restrictions on the rights of bondholders and other lenders could possibly increase the cost of funds or reduce availability. It would be best to let the market decide.
The remarkable rebound of the crisis economies that has now occurred reflects the natural resilience and policy determination of the East Asian countries. These recoveries should not obscure the need for improved policies in both borrower countries and creditor institutions. But the world does not need bold new financial architecture. We do need to return to older common sense ideas for both lenders and borrowers.
Martin Feldstein is President and CEO of the National Bureau of Economic Research and Professor of Economics at Harvard University.