REFORM OF THE INTERNATIONAL FINANCIAL ARCHITECTURE · 2012-06-18 · Towards Reform of the...

Part Two

REFORM OF THE INTERNATIONALFINANCIAL ARCHITECTURE

61Towards Reform of the International Financial Architecture: Which Way Forward?

The increased frequency and virulence ofinternational currency and financial crises, involv-ing even countries with a record of good govern-ance and macroeconomic discipline, suggests thatinstability is global and systemic. Although thereis room to improve national policies and institu-tions, that alone would not be sufficient to dealwith the problem, particularly in developing coun-tries, where the potential threat posed by inher-ently unstable capital flows is much greater. Astrengthening of institutions and arrangementsat the international level is essential if the threatof such crises is to be reduced and if they are tobe better managed whenever they do occur. Yet,despite growing agreement on the global and sys-temic nature of financial instability, the interna-tional community has so far been unable to achievesignificant progress in establishing effective glo-bal arrangements that address the main concernsof developing countries.

In the aftermath of the Asian crisis a numberof proposals have been made by governments,international organizations, academia and marketparticipants for the reform of the international fi-nancial architecture.1 They cover broadly four

areas: global rules and institutions governinginternational capital flows; the exchange rate sys-tem; orderly workouts for international debt; andthe reform of the IMF, with special reference tosurveillance, conditionality, the provision of inter-national liquidity, and its potential function aslender of last resort. Implementation of any ofthese proposals would entail the creation of newinternational institutions and mechanisms as wellas reform of the existing ones.

Some of these proposals have been discussedin the IMF itself, as well as in other internationalfinancial institutions, such as BIS and the newlyestablished Financial Stability Forum (FSF), andalso among the Governments of G-7 countries.While certain initiatives have been taken as aresult, the reform process, rather than focusing oninternational action to address systemic instabil-ity and risks, has placed emphasis on what shouldbe done by national institutions and mechanisms.Even in this regard it has failed to adopt an even-handed approach between debtors and creditors.Efforts have concentrated on disciplining debtors,setting guidelines and standards for major areasof national policy, principally in debtor countries,

Chapter III

TOWARDS REFORM OF THE INTERNATIONALFINANCIAL ARCHITECTURE:

WHICH WAY FORWARD?

A. Introduction

Trade and Development Report, 200162

and providing incentives and sanctions for theirimplementation. Debtor countries have been urgedto better manage risk by adopting strict financialstandards and regulations, carrying adequateamounts of international reserves, establishingcontingent credit lines and making contractual ar-rangements with private creditors so as to involvethem in crisis resolution. The international finan-cial system has continued to be organized aroundthe principle of laissez-faire, and developing coun-tries are advised to adhere to the objective of anopen capital account and convertibility, and toresort to controls over capital flows only as anexceptional and temporary measure. All this hasextended the global reach of financial marketswithout a corresponding strengthening of globalinstitutions.

The failure to achieve greater progress is, toa considerable extent, political in nature. Theproposals referred to abovehave often run into conflictwith the interests of creditors.But governments in some debt-or countries also oppose re-form measures that wouldhave the effect of loweringthe volume of capital inflowsand/or raising their cost, evenwhen such measures could beexpected to reduce instabilityand the frequency of emerg-ing-market crises. Many ob-servers have been quick to dis-miss such proposals as notonly politically unrealistic butalso technically impossible.However, as long as systemicfailure continues to threatenglobal welfare, resistance to more fundamentalreform of the international financial architecturemust be overcome:

It is easy to fall into the trap of thinking thatbig institutional changes are unrealistic orinfeasible, especially in the United Stateswhere macroeconomic policy institutionshave generally evolved only slowly for thepast few decades. Not so long ago, the pros-pects for a single European currency seemed

no more likely than those for the breakupof the Soviet empire or the reunificationof Germany. Perhaps large institutionalchanges only seem impossible until theyhappen – at which point they seem foreor-dained. Even if none of the large-scale plansis feasible in the present world political en-vironment, after another crisis or two, theimpossible may start seeming realistic.(Rogoff, 1999: 28)

Part Two of this Report reviews the main ini-tiatives undertaken so far in the reform of the in-ternational financial architecture, and the advicegiven to developing countries in some key policyareas, such as structural reforms and exchange ratepolicy, for the prevention and management of in-stability and crises. The discussion follows froman earlier analysis, made in TDR 1998, and con-centrates on more recent developments. This chap-ter provides an overview of the issues, comparing

briefly what has so far beenachieved with the kind ofmeasures proposed in order toaddress systemic failures andglobal instability. The nextchapter reviews recent initia-tives regarding global stand-ards and regulation, whilechapter V discusses whetherdeveloping countries can bothkeep an open capital accountand avoid currency instabilityand misalignments by choos-ing appropriate exchange rateregimes, despite persistentmisalignments and gyrationsof the three major reserve cur-rencies and large swings in in-ternational capital flows. It

also assesses the scope for regional cooperationfor establishing collective defence mechanismsagainst financial instability, drawing on the EUexperience. The final chapter takes up the ques-tion of the management of financial crises andburden-sharing, and discusses the current state ofplay in two crucial areas, namely the provision ofinternational liquidity and the involvement of theprivate sector in crisis management and resolu-tion.

Rather than focusing oninternational action toaddress systemic instabilityand risks, the reformprocess has placedemphasis on what shouldbe done by nationalinstitutions and mecha-nisms. Even in this regard ithas failed to adopt an even-handed approach betweendebtors and creditors.


As the Second World War drew to an end, aset of organizations was envisaged which woulddeal with exchange rates and international pay-ments, the reconstruction and rehabilitation of wardamaged economies, and international trade andinvestment. The institutions established to handlethese issues were the IMF, the World Bank, andthe GATT. However, international capital move-ments did not fall within their purview. The origi-nal structure did not include a global regime forcapital movements in largepart because it was consideredthat capital mobility was notcompatible with currency sta-bility and expansion of tradeand employment. However, nosuch regime was establishedeven after the breakdown of theBretton Woods arrangements,despite the growing importanceof private capital flows (Akyüzand Cornford, 1999: 1–7).

The only global regimeapplying to cross-border mon-etary transactions was thatof the IMF, but the most im-portant obligations in its Arti-cles of Agreement relate to current and not capi-tal transactions. Concerning the latter, Article IVstates that one of the essential purposes of the in-ternational monetary system is to provide a frame-work facilitating the exchange of capital amongcountries, a statement which is included amonggeneral obligations regarding exchange arrange-ments. The more specific references to capitaltransfers, in Article VI, permit recourse to capitalcontrols so long as they do not restrict paymentsfor current transactions, and actually give the Fundthe authority to request a member country to im-

pose controls to prevent the use of funds from itsGeneral Resources Account to finance a large orsustained capital outflow. The only recent initia-tive regarding the global regime is the attempt toinclude capital convertibility among the objectivesof the IMF.

The BIS was originally set up as a forum fora small number of countries to deal with only cer-tain aspects of international capital flows.2 Since

the 1970s it has provided sec-retariat support for a numberof bodies established to reduceor manage the risks in cross-border banking transactions.These bodies are not respon-sible for setting rules for in-ternational capital movementsas such. Their work is aimed atreaching agreements on stand-ards to be applied by nationalauthorities for strengtheningthe defences of financial firms,both individually and in theaggregate against destabiliza-tion due to cross-border trans-actions and risk exposures.

The increased frequency of financial crises,together with the increasingly global character offinancial markets, has prompted both analysts andpractioners to formulate proposals for the crea-tion of a number of international institutionsexplicitly designed to regulate and stabilize inter-national capital flows. One such proposal is forthe creation of a global mega-agency for finan-cial regulation and supervision, or World FinancialAuthority, with responsibility for setting regula-tory standards for all financial enterprises, offshoreas well as onshore (Eatwell and Taylor, 1998; 2000).

B. The governance of international capital flows

The obligations contained inthe new codes andstandards initiatives seem toreflect the view that the mainflaws in the system forinternational capital move-ments are to be found inrecipient countries, whichshould thus bear the mainburden of the adjustmentsneeded to prevent or containfinancial crises.


Another proposal is to establish a Board of Overse-ers of Major International Institutions and Markets,with wide-ranging powers for setting standardsand for the oversight and regulation of commercialbanking, securities business and insurance.3 Yetanother proposal, which focuses on stabilizing in-ternational bank lending, is for the establishmentof an International Credit Insurance Corporationdesigned to reduce the likelihood of excessivecredit expansion (Soros, 1998).

These proposals are based on two arguments.The first is that, since financial businesses arebecoming increasingly interrelated and operateacross borders, their regula-tion and supervision should alsobe carried out on a unified andglobal basis. The second argu-ment focuses on the instabil-ity of capital movements un-der the present patchwork ofregimes, which only more glo-bally uniform regulation couldbe expected to address. What-ever their specific strengthsand weaknesses, these propos-als emphasize the need for in-ternational institutions andmechanisms that can preventexcessive risk-taking in cross-border lending and invest-ment, reduce systemic fail-ures, and eliminate several, of-ten glaring, lacunae in the na-tional regulatory regimes of creditor and debtorcountries. The official approach to these problemshas been quite different, focusing on loweringthe risk of financial distress and contagion bystrengthening the domestic financial systems indebtor countries. It has also emphasized theprovision of timely and adequate information re-garding the activities of the public sector and fi-nancial markets in debtor countries in order to al-low international lenders and creditors to makebetter decisions, thereby reducing market failure,as well as to improve bilateral surveillance.

As examined in some detail in chapter IV,various codes and standards have been establishedthrough institutions such as the IMF, BIS and theFSF not only for the financial sector itself, butalso in respect of macroeconomic policy and

policy regarding disclosure. While their applica-tion should be generally beneficial, particularlyover the long term, they will not necessarily con-tribute to financial stability, and in many casesthey will involve substantial initial costs. More-over, the programmes of reform required of recipi-ent countries are wide-ranging and do not alwaysaccommodate differences in levels of developmentand the availability of human resources.

Considered from the standpoint of systemicreform, the reform package contains many omis-sions and reflects an asymmetric view of differ-ent parties’ responsibilities for the changes re-

quired. In particular, it doesnot adequately address theconcerns of developing coun-tries over the frequently sup-ply-driven character of fluc-tuations in international capi-tal flows, which are stronglyinfluenced by monetary con-ditions in major industrialcountries, especially theUnited States, and over the li-quidity positions and herd be-haviour of lenders and inves-tors in those countries. The ob-ligations contained in the newcodes and standards initiativesseem to reflect the view thatthe main flaws in the systemfor international capital move-ments are to be found in re-

cipient countries, which should thus bear the mainburden of the adjustments needed to prevent orcontain financial crises. By contrast, new meas-ures to reduce volatile capital flows at source orto increase the transparency of currently largelyunregulated cross-border financial operations arenotable mostly for their inadequacy or their com-plete absence. The recommendations directed atsource countries call for only limited actions thatare beyond the bounds of existing policies or ini-tiatives or involve changes in market practicesbeyond those already being undertaken.

Despite the emphasis on ownership and vol-untary participation, implementation of the codesand standards is to be backed by an extensive sys-tem of externally applied incentives and sanctions,some of which risk becoming features of IMF

“… there are dangers inthrowing at developingcountries a Washington-consensus view of economicpolicy, even if this consensusis now refurbished with newinternational codes andstandards … the new set ofexternal disciplines comehand-in-hand with aparticular model ofeconomic development ofdoubtful worth …”


conditionality. Although the rules and guidelinesare mostly of a fairly general nature, there remainsa danger that their actual implementation willincorporate elements from particular developed-country models, owing to the role in assessmentexercises of multilateral financial institutions andsupervisors from G-7 countries. As one writer hasput it:

… there are dangers in throwing at develop-ing countries a Washington-consensus view ofeconomic policy, even if this consensus is nowrefurbished with new international codes andstandards and with “second-generationreforms”. The dangers arise from severalsources. First, the new set of external disci-plines come hand-in-hand with a particularmodel of economic development of doubtfulworth … Second, it is doubtful that the newpolicy agenda will make the international sys-tem itself much safer. … Indeed, by focusingattention on internal structural reforms in thedeveloping world, the current approach leadsto complacency on short-term capital flows,and could increase rather than reduce systemic

risks. Finally, the practical difficulties of im-plementing many of the institutional reformsunder discussion are severely underestimated.(Rodrik, 1999: 3)

What has been proposed so far under theheading of codes and standards falls well short ofamounting to an integral component of a newglobal policy framework for reducing financialinstability. It should be recalled that an essentialelement of the rationale of the codes and stand-ards initiatives consisted of their role as the nec-essary counterpart of further financial liberaliza-tion, particularly in developing economies. But theinitiatives currently under consideration hardlyjustify imposing further obligations on countriesas to capital-account convertibility, cross-borderinvestment, or the liberalization of financial serv-ices more generally. In the absence of effectiveglobal action, much of the burden of coping withinternational financial instability still falls on na-tional governments. It is thus vital that they re-main free in their choice of policy.

C. The exchange rate system

The second key area in the reform of the in-ternational financial architecture is the exchangerate system, notably the arrangements regardingthe three major reserve currencies (the dollar, theeuro and the yen). Indeed, it would be more ap-propriate to speak of the need to establish a glo-bal system of exchange rates rather than reformthe existing system; ever since the breakdown ofthe Bretton Woods system of fixed, but adjustable,exchange rates there have in effect been no glo-bal arrangements. While floating was adopted onthe understanding that success depended upon the

prevalence of orderly underlying conditions, theinternational arrangements to that end as speci-fied in the Articles of Agreement of the IMF, andin the April 1977 decision on exchange rate ar-rangements, failed to define the obligations andcommitments that such arrangements involved. Aspointed out by Robert Triffin, the obligations were“so general and obvious as to appear rather su-perfluous”, and the system “essentially proposedto legalize … the widespread and illegal repudia-tion of Bretton Woods commitments, withoutputting any other binding commitments in their


place” (Triffin, 1976: 47–48). While the April 1977decision required members to “intervene in theexchange market if necessary to counter dis-orderly conditions”, it failed to define these con-ditions and to provide explicit guidelines for in-tervention. Similarly, the principles of surveillanceover exchange rate policies “were sufficiently gen-eral for constraint on behaviour to depend almostentirely on the surveillance procedures” (Dam,1982: 259), and the consultation procedures haveso far failed to generate specific rules of conductthat could lend support to any contention that thepresent arrangements constitute a “system”.4

Given this institutional hia-tus and lack of policy coordi-nation among the major indus-trial countries, it should comeas no surprise that floating hasfailed to deliver what was origi-nally expected: reasonably sta-ble exchange rates; orderlybalance-of-payments adjust-ment; greater macroeconomicpolicy autonomy; and removalof asymmetries between de-ficit and surplus countries.Rather, the system is charac-terized not only by short-termvolatility, but also by persist-ent currency misalignmentsand gyrations. The major in-dustrial countries have contin-ued to favour floating and haverefrained from intervening in currency marketsexcept at times of acute stress and imbalances, suchas the events leading to agreements on coordinatedmonetary policy actions and exchange market in-terventions in the Plaza and Louvre Accords of1985 and 1987, respectively.

The damage inflicted by disorderly exchangerate behaviour tends to be limited for the reservecurrency (G-3) countries themselves, compared todeveloping countries, because they have largeeconomies that are much less dependent on inter-national trade. Moreover, the exposure of theireconomic agents to exchange rate risks is limitedbecause they can both lend and borrow in theirnational currencies. By contrast, exchange ratemisalignments and gyrations among the G-3currencies are a major source of disturbance for

developing countries that has played an impor-tant role in almost all major emerging-market cri-ses (Akyüz and Cornford, 1999: 31). Thus, the ques-tion arises whether it is meaningful to predicateattainment of exchange rate stability by emerging-market countries purely on their adoption of ap-propriate macroeconomic policies and exchangerate regimes when the currencies of the majorindustrial countries are still so unstable. Indeed,many observers have suggested that the globaleconomy will not achieve greater systemic stabil-ity without some reform of the G-3 exchange rateregime, and that emerging markets will continue

to be vulnerable to currencycrises as long as the major re-serve currencies remain highlyunstable.

Certainly, given the de-gree of global interdependence,a stable system of exchangerates and payments positionscalls for a minimum degree ofcoherence among the macr-oeconomic policies of majorindustrial countries. But theexisting modalities of multilat-eral surveillance do not in-clude ways of attaining suchcoherence or dealing with uni-directional impulses resultingfrom changes in the monetaryand exchange rate policies ofthe United States and other

major industrial countries. In this respect govern-ance in macroeconomic and financial policieslacks the kind of multilateral disciplines that ex-ist for international trade.

One proposal to attain stable and properlyaligned exchange rates is through the introduc-tion of target zones among the three majorcurrencies together with a commitment by thecountries to defend such zones through coordi-nated intervention and macroeconomic policyaction.5 It is felt that such a commitment wouldsecure the policy coherence needed for exchangerate stability without undermining growth andcould alter the behaviour of currency markets,which, in turn, would reduce the need for inter-vention. Such an arrangement could be institution-alized and placed under IMF surveillance.

Can emerging-marketcountries attain exchangerate stability purely byadopting appropriatemacroeconomic policiesand exchange rate regimeswhen the currencies of themajor industrial countriesare still so unstable? Theexchange rate system assuch has hardly figured onthe agenda for the reformof the international financialarchitecture.


A more radical proposal is to do away withexchange rates and adopt a single world currency,to be issued by a World Monetary Authority whichcould also act as a lender of last resort. There hasbeen growing interest in such an arrangement sincethe introduction of the euro and the recurrent cur-rency crises in emerging markets. However, it isgenerally felt that the present extent of economicconvergence and depth of glo-bal integration fall far short ofwhat would be required forsuch an arrangement to oper-ate effectively (Rogoff, 1999:33–34).

In any event, it is inter-esting to note that the ex-change rate system has hardlyfigured on the agenda for thereform of the international fi-nancial architecture. The report by the then Act-ing Managing Director of IMF to the InternationalMonetary and Financial Committee (IMF, 2000b)recognized the difficult choice faced by mostcountries between maintaining, on the one hand,truly flexible rates and, on the other, hard pegs.Referring to the three major currencies, the re-port pointed to “large misalignments and vola-tility” in their exchange rates as a cause for con-cern, particularly for small, open commodity-exporting countries. However, it did not discussany initiatives that might betaken by the international com-munity in this respect, im-plying that the matter couldonly be sorted out betweenthe United States, Japan andthe EU (see also Culpeper,2000: 15).

Indeed, as noted in chap-ter V, discussions on exchangerates have concentrated on thekind of regimes that develop-ing countries would need toadopt in order to attain greater stability. The main-stream advice is to choose between free floatingor locking into a reserve currency through cur-rency boards or dollarization (the “hard” pegs),thus opting for one of the two “corner” solutions,as opposed to intermediate regimes of adjustableor soft pegs. Increasingly questions are being

raised as to whether the existence of so many in-dependent currencies makes sense in a closely in-tegrated global financial system.

However, much of this is a false debate.Whichever option is chosen, it will not be able toensure appropriate alignment and stability ofexchange rates in developing countries as long

as major reserve currenciesthemselves are so unstable andmisaligned, and internationalcapital flows are volatile andbeyond the control of recipi-ent countries. Moreover, suchconditions create inconsist-encies within the developingworld in attaining orderly ex-change rates. Briefly put, thereis no satisfactory unilateral so-lution to exchange rate instabil-

ity and misalignments in emerging markets, par-ticularly under free capital movements.

Since global arrangements for a stable sys-tem are not on the immediate agenda, the ques-tion arises as to whether regional mechanismscould provide a way out. Indeed, there is now agrowing interest in East Asia and some countriesof South America in regionalization (as opposedto dollarization) as a means of providing a collec-tive defence mechanism against systemic failures

and instability. The EU expe-rience holds useful lessons inthis respect, including the in-stitutional arrangements forthe maintenance and adjust-ment of intraregional curren-cy bands, intervention mecha-nisms, regimes for capitalmovements, and various facili-ties designed to provide pay-ments support to individualcountries and regional lender-of-last-resort services. How-ever, applying this experience

to arrangements among developing countriesposes certain difficulties, particularly with respectto the exchange rate regime to be pursued vis-à-vis reserve currencies and access to internationalliquidity, issues of special importance under con-ditions of intraregional contagion. Regional mon-etary arrangements among emerging markets

Governance in macro-economic and financialpolicies lacks the kind ofmultilateral disciplinesthat exist for internationaltrade.

There is now a growinginterest in East Asia andsome countries of SouthAmerica in regionalizationas a means of providing acollective defence mecha-nism against systemicfailures and instability.


could thus be greatly facilitated if they involvedalso the major reserve-currency countries. In thisrespect, the recent initiatives taken by ASEAN+3

(see chapter V, box 5.1) constitute an importantstep along what may prove to be a long and diffi-cult path to closer regional monetary integration.

D. Orderly workout mechanisms for international debt

A third major area of reform concerns orderlyworkout mechanisms for international debt. Suchmechanisms have gained added importance inview of shortcomings in global arrangements forthe prevention of financial crises. The prospectthat crises will continue to occur, even with in-creasing frequency and severity, poses a dilemmafor the international community. Once a crisisoccurs, it is difficult to avoid widespread messydefaults on external liabilities in the absence ofbailouts, with attendant consequences for inter-national financial stability. But bailouts are be-coming increasingly problematic. Not only do theycreate moral hazard for lenders, but also they shiftthe burden onto debtor countries and their tax-payers, who ultimately pay off the official debt.Furthermore, the funds required have been get-ting larger and more difficult to raise. For thesereasons, one of the main issues in the reformagenda is how to “involve” or “bail in” the pri-vate sector in crisis management and resolutionso as to redress the balance of burden-sharing be-tween official and private creditors as well asbetween debtor and creditor countries.

One way out of this dilemma would be re-course to the principles of orderly debt workoutsalong the lines of chapter 11 of the United StatesBankruptcy Code, a proposal first put forward bythe UNCTAD secretariat (in TDR 1986) in thecontext of the debt crisis of the 1980s, and morerecently re-examined by it (in TDR 1998) in rela-tion to emerging-market crises. Application ofthese principles would be especially relevant tointernational currency and debt crises resultingfrom liquidity problems because they are designed

primarily to address financial restructuring ratherthan liquidation. They allow a temporary stand-still on debt servicing based on recognition that agrab race for assets by creditors is detrimental tothe debtor as well as to the creditors themselvesas a group. They provide the debtor with accessto the working capital needed to carry out its op-erations while granting seniority status to newdebt. Finally, they involve reorganization of theassets and liabilities of the debtor, includingextension of maturities and, where needed, debt-equity conversion and debt write-off.

One way to implement these principles is tocreate an international bankruptcy court in orderto apply an international version of chapter 11 (or,as appropriate, chapter 9) drawn up in the form ofan international treaty ratified by all members ofthe United Nations (Raffer, 1990). However, full-fledged international bankruptcy procedures arenot necessary to ensure an orderly workout forinternational debt. Another option would be toestablish a framework for the application to inter-national debtors of key insolvency principles,namely debt standstill and lending into arrears(i.e. lending to a debtor in arrears to its creditor).Since prompt action is necessary to ward off specu-lative attacks and financial panic, the decision forstandstill should rest with the debtor country andthen be sanctioned by an international body, so asto provide the debtor with insolvency protectionin the national courts of creditor countries. Re-structuring of private debt could then be left tonational bankruptcy procedures, while for sover-eign debt direct negotiations with creditors appearto be the only feasible solution.


As discussed in chapter VI, while it has beenincreasingly accepted that market discipline willonly work if creditors bear the consequences ofthe risks they take, the international communityhas not been able to reach an agreement on howto involve the private sector in crisis managementand resolution. Even though a framework such asthe one described above has found considerablesupport among many industrial countries, there isstrong opposition from some major powers, andfrom participants in privatemarkets, to mandatory mecha-nisms for “binding in” and“bailing in” the private sector.Considering that such mecha-nisms would alter the balanceof negotiating strength betweendebtors and creditors and cre-ate moral hazard for debtors,they advocate, instead, volun-tary and contractual arrange-ments between debtors andcreditors to facilitate debt work-outs, such as the insertion ofcollective action clauses in bondcontracts. Moreover, a numberof middle-income countries,particularly those with a rela-tively high degree of depend-ence on financial inflows, areopposed to both mandatorystandstills and the inclusion ofcollective action clauses inbond contracts for fear thattheir access to international financial marketswould be impaired.

The discussions in the IMF Executive Boardon this issue emphasized the catalytic role of theFund in involving the private sector and that, ifthe latter did not respond, the debtor countryshould seek agreement with its creditors on a vol-untary standstill. The Board recognized that, “inextreme circumstances, if it is not possible to reachagreement on a voluntary standstill, members mayfind it necessary, as a last resort, to impose oneunilaterally”. However, there is no agreement overempowering the IMF, through an amendment ofits Articles of Agreement, to impose a stay oncreditor litigation in order to provide statutory pro-tection to debtors imposing temporary standstills.While it is generally accepted that the Fund may

signal its acceptance of a unilateral standstill bylending into arrears, no explicit guidelines havebeen established on when and how such supportwould be provided, thus leaving considerable dis-cretion to the Fund and its major shareholdersregarding the modalities of its intervention in fi-nancial crises in emerging markets.

As in other areas, the reform process has thusbeen unable to establish an appropriate interna-

tional framework for involv-ing the private sector in themanagement and resolution offinancial crises, passing thebuck again to debtor countries.True enough, contractual ar-rangements, such as collectiveaction clauses in bond con-tracts and call options in inter-bank credit lines, can provideconsiderable relief for coun-tries facing debt servicing dif-ficulties, and the misgivingsthat such arrangements mayimpede access to capital mar-kets may be misplaced. Butthese are not matters for con-sideration in the reform of theinternational financial archi-tecture, unless global mecha-nisms are introduced to facili-tate such arrangements. Thereis also resistance to introduc-ing automatic rollover and col-

lective action clauses in international debt con-tracts based on an international mandate. Further-more, certain features of external debt of devel-oping countries, including wide dispersion ofcreditors and debtors and the existence of a largevariety of debt contracts, governed by differentlaws, render it extremely difficult to rely on vol-untary mechanisms for securing rapid debt stand-stills and rollovers. Without a statutory protectionof debtors, negotiations with creditors for restruc-turing loans cannot be expected to result in equi-table burden sharing. Indeed, in recent examplesof negotiated settlements the creditors have notborne the consequences of the risk they had taken;rather, they have forced the developing countrygovernments to assume responsibility for the pri-vate debt and accept a simple maturity extensionat penalty rates.

The IMF Board recognizedthat, “in extremecircumstances, if it is notpossible to reachagreement on a voluntarystandstill, members mayfind it necessary, as a lastresort, to impose oneunilaterally”. However, thereis no agreement overempowering the IMF toimpose a stay on creditorlitigation in order to providestatutory protection todebtors imposingtemporary standstills.


Naturally, reforms and recent initiatives inthe areas discussed above generally imply sig-nificant changes in the mandate and policies ofthe IMF, particularly with respect to bilateraland multilateral surveillance, conditionality andthe provision of international liquidity. As notedabove, the Fund is closely involved in settingcodes and standards for macroeconomic andfinancial policies and monitoring compliance, andeffective multilateral surveillance is a prerequi-site for a stable system of exchange rates. Privatesector involvement in crisis management and reso-lution also crucially depends on IMF lending poli-cies, as well as on its support and sanctioning ofstandstills and capital and exchange controls.Consequently, the reform of the international fi-nancial architecture presupposes a reform of theIMF.

1. Surveillance and conditionality

As discussed in TDR 1998, asymmetries inIMF surveillance, in the aftermath of the EastAsian crisis, along with excessive conditionalityattached to IMF lending, were widely consideredto be two of the principal areas deserving atten-tion in the reform of the international financialarchitecture. However, the recent approach to re-form has resulted in increased asymmetries insurveillance and in enhanced conditionality, sinceit has focused primarily on policy and institutionalshortcomings in debtor countries.

As already noted, surveillance has not beensuccessful in ensuring stable and appropriatelyaligned exchange rates among the three major re-serve currencies. Nor has it been able to protectweaker and smaller economies against adverse im-pulses originating from monetary and financialpolicies in the major industrial countries. It is truethat the need for stronger IMF surveillance in re-sponse to conditions produced by greater globalfinancial integration and recurrent crises was rec-ognized by the Interim Committee in April 1998,when it agreed that the Fund “should intensify itssurveillance of financial sector issues and capitalflows, giving particular attention to policy inter-dependence and risks of contagion, and ensure thatit is fully aware of market views and perspectives”(IMF Interim Committee Communiqué of 16 April1998). However, despite the reference to interde-pendence and contagion, these proposals have notso far been effectively extended to cover weak-nesses arising from the lack of balance in existingprocedures.

Rather, there has been an intensification ofIMF surveillance and conditionality as a result oftheir extension to financial sector issues in debtorcountries, in accordance with the diagnosis thatthis is where the main problem lies. As notedabove, new codes and standards are likely to re-sult in enhanced conditionality, particularly for theuse of new facilities, including contingency fi-nancing, for overcoming financial crises. Quiteapart from whether the result could be unneces-sary interference with the proper jurisdiction of asovereign government, as some commentatorsbelieved it was in the Republic of Korea (Feld-

E. Reform of the IMF


stein, 1998), there is also the potential problemthat the type of measures and institutions promotedmay not be the appropriate ones:

An unappreciated irony in this is that con-ditionality on developing countries is beingratcheted up at precisely the moment whenour comprehension of how the worldeconomy works and what small countriesneed to do to prosper within it has beenrevealed to be sorely lacking. (Rodrik,1999: 2)

The International Monetary and FinancialCommittee (IMFC, formerly the Interim Commit-tee), recognizing the need to streamline IMFconditionality, has urged “the Executive Board totake forward its review of all aspects of policyconditionality associated with Fund financing inorder to ensure that, while not weakening thatconditionality, it focuses on the most essential is-sues”.6 For his part, the Fund’s new ManagingDirector, Horst Köhler, has likewise concluded that:

To strengthen its efficiency and legitimacy,the Fund needs to refocus. The Fund’s focusmust clearly be to promote macroeconomicstability as an essential condition for sus-tained growth. To pursue this objective, theFund has to concentrate on fostering soundmonetary, fiscal and exchange rate policies,along with their institutional underpinningand closely related structural reforms. …I trust that ownership is promoted when theFund’s conditionality focuses in content andtiming predominantly on what is crucial forthe achievement of macroeconomic stabil-ity and growth. Less can be more if it helpsto break the ground for sustained process ofadjustment and growth.7

Perhaps it is too early to judge how far inpractice this refocusing has been pursued, but itis notable that the recent Fund programmes inTurkey and Argentina show no significant ten-dency to depart from past practice (see chapter II,boxes 2.1 and 2.2). They stipulate a wide rangeof policy actions not only in the purview of otherinternational organizations, such as WTO and thedevelopment banks, but also of national economicand social development strategies, including ac-tions relating to privatization and deregulation,agricultural support, social security and pensionsystems, industrial and competition policy, andtrade policy.

2. Liquidity provision andlender-of-last-resort financing

The other major area of reform concerns theprovision of adequate liquidity. A consensus hasemerged over the past decade that the Fund shouldprovide international liquidity not only to coun-tries facing payments difficulties on current ac-count but also to those facing crises on capitalaccount. Two main facilities have been establishedfor this purpose: a Supplemental Reserve Facility(SRF) for countries already facing paymentsdifficulties, and a Contingency Credit Line (CCL)to provide a precautionary line of defence againstinternational financial contagion (see chapter VI,box 6.3). While there are difficulties regarding theterms and conditions attached to such facilities,the real issue is whether and to what extentprovision of such financing conflicts with, or com-plements the objective of, involving private credi-tors and investors in the management and resolu-tion of emerging-market crises.

In several debtor countries, governmentsappear to favour unlimited liquidity support, re-gardless of the terms and conditions and theburden that may eventually be placed on the coun-try’s tax payers by international rescue operations.This attitude is consistent with their aversion toimposing temporary payments standstills and capi-tal and exchange controls at times of crisis. Onthe other hand, while there is no consensus in theIMF Board on mandatory arrangements for involv-ing the private sector, there is now a growingemphasis on making official assistance conditionalon private sector participation. However, no formallimits have been set for access to Fund resourcesbeyond which such participation would be re-quired. As discussed in chapter VI, absence ofexplicit access limits as well as of mandatorystandstill mechanisms may render it extremelydifficult to secure private sector involvement, forc-ing the Fund to engage in large-scale interventions.

Indeed, since the main objective of large-scale contingency or crisis financing would be toallow debtor countries to remain current on pay-ments to their creditors, it is difficult to see howthis could be reconciled with a meaningful pri-vate sector involvement in crisis resolution andburden sharing. Consequently, a credible and ef-


fective strategy for involving the private sectorshould combine temporary standstills with strictlimits on access to Fund resources. While there isgrowing agreement on theneed to limit crisis lending, itis also suggested that theremay be a need for exception-ally large contingency financ-ing when the crisis appearsto be “systemic”. In practice,such an approach could resultin differentiation among debt-or countries: those for whichthe crisis is considered “sys-temic” would be eligible forconsiderable liquidity supportwithout any prior condition forprivate sector participation, asin recent operations in Argen-tina and Turkey; those wherethe crisis is not so consideredwould face strict limits andwould be encouraged to involve the private sec-tor through default, as seems to have been the casefor Ecuador and Pakistan.

There are proposals to go further and allowthe IMF to act as, or to transform that institutioninto, an international lender of last resort foremerging markets. Proposals of this nature havebeen put forward by the Deputy Managing Direc-tor of the Fund (Fischer, 1999) and, in the broadercontext of reforming the international financialinstitutions, by the International Financial Insti-tutions Advisory Commission (Meltzer Commis-sion). Indeed, the idea has received much greatersympathy than any other proposal for institutionalchanges at the global level, from among peoplewith sharply different views about the reform ofthe IMF and situated at opposite ends of thepolitical spectrum, although certain aspects ofthe Meltzer Commission’s recommendations arehighly contentious.8 The key suggestion is thatcountries meeting certain ex ante conditions forsolvency should be eligible for lender-of-last-resort financing. In the proposal by the MeltzerCommission, access to liquidity would be auto-matic for countries meeting a priori requirements,and no additional conditionality or negotiationswould be required. Lending would be limited toa maximum of one year’s tax revenue of the bor-rowing country. This could result in far greater

packages than any crisis lending by the IMF sofar. The problem of moral hazard would be tackledby conditionality rather than by tighter limits on

lending. By contrast, the re-port does not make any recom-mendation for involving theprivate sector, except to sug-gest that, for the time being,the matter should be left tonegotiations between debtorsand creditors.

Arrangements of this na-ture would, however, compoundcertain problems encounteredin the current practice regard-ing IMF bailouts. Without dis-cretion to create its own li-quidity, the Fund would haveto rely on major industrial coun-tries to secure the funds neededfor such operations. In such

circumstances it is highly questionable whether itwould really be able to act as an impartial lenderof last resort, analogous to a national central bank,since its decisions and resources would dependon the consent of its major shareholders, who aretypically creditors of those countries experiencingexternal financial difficulties. This problem couldbe partly overcome by authorizing the Fund toissue permanent or reversible SDRs, but attribut-ing such a key role to the SDR would face strongopposition from the same source.

Furthermore, there are also political and tech-nical difficulties regarding the terms of access tosuch a facility. Financing by a genuine inter-national lender of last resort, which would beunlimited and unconditional except for penaltyrates, would require very tight global supervisionover borrowers to ensure their solvency, whichit would not be easy to reconcile with nationalsovereignty. Nor would prequalification be com-patible with the practice of “constructive ambi-guity” that all modern national lenders of resortare said to follow.9 It would also require the IMFto act as a de facto credit-rating agency. However,it is very difficult to establish generally agreedstandards for solvency, and assessments of a givenset of economic indicators can vary considerably,as evidenced by differences among private ratingagencies (Akyüz and Cornford, 1999: 48). Dis-

Since the main objective oflarge-scale contingency orcrisis financing would be toallow debtor countries toremain current onpayments to their creditors,it is difficult to see how thiscould be reconciled with ameaningful private sectorinvolvement in crisisresolution and burdensharing.


agreements in this respect between the develop-ing countries concerned and the Fund staff couldlead the countries to opt out and seek alternativearrangements, thereby reducing the effectivenessof the proposed mechanism. Moreover, since itwould be necessary constantly to monitor the ful-filment of the preconditions, adjusting them asnecessary in response to changes in financial mar-kets or other changes beyond the control of theGovernment of the recipient country, prequali-fication would not avoid difficulties in relationsbetween the Fund and the member concerned.

Transforming the Fund into an internationallender of last resort would involve a fundamentaldeparture from the underlying premises of theBretton Woods system, which provided for the useof capital controls to deal with instability. In dis-cussion of such a facility its introduction is fre-quently linked to concomitant arrangementsregarding rights and obliga-tions with respect to interna-tional capital transactions, to-gether with a basic commit-ment to capital-account liber-alization. This departure fromthe Bretton Woods arrange-ments is particularly notable inthe report of the Meltzer Com-mission, which virtually pro-poses, inter alia, the discon-tinuation of all other forms ofIMF lending, including thosefor current account financing.Such a drastic shift in the na-ture of IMF lending, from cur-rent account to capital accountfinancing, would lead to a fur-ther segmentation of the Fund’s membership,with consequences for its governance and uni-versality. Indeed, as noted by a former UnitedStates Treasury Secretary, only a small number

of relatively prosperous emerging economieswould be eligible for lender-of-last-resort financ-ing.10

Moreover, under these proposals, a large ma-jority of developing countries would be excludedfrom multilateral financing. The Meltzer Commis-sion argued, throughout its discussion of lendingpolicies by both IMF and the World Bank, that cur-rent account financing to developing countriesshould, in principle, be provided by private mar-kets. However, markets cannot always be reliedon to fulfil this task properly. One of the originalobjectives of the IMF was to provide short-termfinancing when reserves were inadequate to meetcurrent account needs resulting from temporarytrading shocks and disturbances, while the WorldBank was to meet longer-term financing needs ofreconstruction and development. For temporarypayments disequilibrium, it was agreed that short-

term financing was necessaryin order to avoid sharp cutsin domestic absorption or dis-ruptive exchange rate adjust-ments. Even when the effectsof such shocks were deemedto be more lasting, IMF financ-ing was believed to be neces-sary to allow orderly adjust-ment. Experience shows thatfinancial markets often fail tomeet such needs since theytend to be pro-cyclical, withthe result that credit lines arecut off just when they are mostneeded. Given the increasedinstability of the external trad-ing and financial environment

of developing countries, a reform of the BrettonWoods institutions should seek to improve, ratherthan eliminate, counter-cyclical and emergency fi-nancing of the current account.

Given the increasedinstability of the externaltrading and financialenvironment of developingcountries, a reform of theBretton Woods institutionsshould seek to improve,rather than eliminate,counter-cyclical andemergency financing of thecurrent account.


There are certainly conceptual and technicaldifficulties in designing effective global mecha-nisms for the prevention and management offinancial instability and crises. Such difficultiesare also encountered in designing national finan-cial safety nets, and explain why a fail-safe systemis unreachable. At the international level thereis the additional problem that any system of con-trol and intervention would need to be reconciledwith national sovereignty and accommodate thediversity among nations. Political constraints andconflicts of interest, including among the G-7members themselves, rather than conceptual andtechnical problems, appear to be the main reasonwhy the international community has not been ableto achieve significant progress in setting up ef-fective global arrangements.

So far the major industrial countries have notaddressed the establishment of a multilateral sys-tem for international finance based on a few coreprinciples and rules preferring instead a strength-ening of the financial systems of debtor countriesin crisis prevention, and favouring a differenti-ated, case-by-case approach to crisis intervention.This approach not only has created asymmetry be-tween debtors and creditors, but also has left fartoo much discretion with the major creditor coun-tries, on account of their leverage in internationalfinancial institutions. It has kept out of the reformagenda many issues of immediate concern to de-veloping countries, which are discussed in thefollowing chapters. However, even a rules-basedsystem raises concerns for developing countries:under the current distribution of power and gov-ernance of global institutions, such a system wouldbe likely to reflect the interests of larger and richer

countries rather than to redress the imbalancesbetween international debtors and creditors. Suchbiases against developing countries already existin the rules-based trading system, although rela-tions here are more symmetrical than in thefinancial domain.

If reforms to the existing financial structuresare to be credible, they must provide for greatercollective influence from developing countries andembody a genuine spirit of cooperation among allcountries, facing many different problems butsharing a common desire to see a more stable in-ternational financial and monetary system. No lessthan a fundamental reform of the governance ofmultilateral institutions is therefore necessary.11

The areas in which reform is needed are exploredin a study undertaken for the G-24, which arguesthat governance within the Bretton Woods insti-tutions needs to be improved regarding suchmatters as representation and ownership, account-ability and transparency, and adaptation andchange:

The allocation of quotas and the correlatemembership rights in both institutions nolonger reflect the application of a coherent,justifiable set of principles: quotas no longerreflect relative economic and political power,and the principle of equal representation,which was once implemented by the alloca-tion of “basic votes”, has been significantlyeroded. Furthermore, decision-making prac-tices have not adapted to the changed man-dates of both institutions, whose work nowtakes them further and further into influenc-ing domestic policy choices in developingcountries. (Woods, 1998: 95)

F. Governance of international finance


While, as recognized in that study, effortshave been made to respond to calls for more trans-parent, accountable and participatory governance,the basic modalities and pro-cedures for taking decisions re-main largely unchanged. Thus,whereas developed countriesaccount for only 17 per cent ofvoting strength in the UnitedNations, 24 per cent in WTO,and 34 per cent in the Interna-tional Fund for AgriculturalDevelopment (IFAD), they ac-count for over 61 per cent inthe Bretton Woods institu-tions. And a single countryholds virtual veto power overimportant decisions such ascapital increases or SDR allocations. It is nowagreed in many quarters that the procedures forselection of the Managing Director of IMF andthe President of the World Bank should givegreater weight to the views of developing and tran-sition economies, since the raison d’être of theseinstitutions is now to be found mainly in their man-dates and operations with respect to these econo-mies. More fundamentally, crucial decisions onglobal issues are often taken outside the appro-priate multilateral forums in various groupings ofmajor industrial countries such as the G-7 or G-10,where there is no developing country representa-tion or participation. Consequently, “nothing con-sequential happens in the formally constituted or-ganizations that do have operational capabilities– the IMF, the World Bank, the Bank for Interna-tional Settlements – without the prior consent, andusually the active endorsement, of the ‘Gs’ (hereused as a short form for all the deliberative groupsand committees dominated by the major industrialcountries)” (Culpeper 2000: 5).

The inclusion of developing countries in thediscussions of financial architecture reform thattake place outside the Bretton Woods institutions,notably in the newly created G-20, is thus gener-ally welcomed as an important step in ensuringbetter participation and governance in interna-tional finance. However, even though its firstchairman, the Canadian Finance Minister PaulMartin, declared that the G-20 “has a mandate toexplore virtually every area of international fi-nance and the potential to deal with some of the

most visible and troubling aspects of today’sintegrated world economy”,12 so far the focus ofits work has not substantially deviated from

the G-7 reform agenda, includ-ing a stock-taking of progressmade by all members in reduc-ing vulnerabilities to crises,an evaluation of countries’compliance with internationalcodes and standards, the com-pletion of the so-called trans-parency reports, and an exami-nation of different exchangerate regimes and their role indebtor countries in cushioningthe impact of international fi-nancial crises (Culpeper, 2000:19). Furthermore, despite the

G-20’s broader membership, there are still seri-ous limitations on participation and accountabil-ity:

The G-20 is severely flawed in that it con-tains no representation … from the poorestand smallest developing countries. … Pre-sumably, this is because the poorest andsmallest are unlikely ever to constitute anysystemic threat. But there are major “archi-tectural” issues surrounding the provisionof adequate development finance to thesecountries and their peoples. … Nor does theG-20 possess any mechanisms either for re-porting or for accountability to the broaderinternational community, such as the con-stituency system provides within the IMFand World Bank, or any provisions fornon-governmental inputs or transparency.(Helleiner, 2000: 13–14)

A number of proposals have been made onhow to reform the multilateral process as well asto improve the membership, accountability andreform agenda of the G-20. Certainly, progress inthese areas will depend on the willingness of themajor industrial countries to extend the reformagenda and process so that they also address theconcerns of developing countries. It will dependno less on positions taken by developing coun-tries themselves. As noted above, there is no con-sensus among the developing countries on sev-eral issues of the reform agenda. Many of the dif-ferences pertain to the modalities of official in-tervention in the management and resolution of

If reforms to the existingfinancial structures are tobe credible, they mustprovide for greatercollective influence fromdeveloping countries andembody a genuine spirit ofcooperation.


financial crises. Most countries appear to givepriority to access to large amounts of contingencyfinancing as a defence against contagion and in-stability, despite their con-cerns as to the appropriatenessof several of its features. Attimes of crisis many countriesseem unwilling to impose tem-porary standstills, preferringofficial bailouts, even thoughthey often complain that theirterms and conditions deepenthe crisis, put an unfair shareof the burden of adjustment onthe debtors, and allow thecreditors to get away scot-free.This unwillingness may partlyreflect an assessment that therisks of imposing a standstillare excessively high when suchaction is still considered an aberrant response to acrisis (so far resorted to by only a few countries).

There appears to be greater convergence ofviews and interests regarding measures for crisisprevention and governance of international fi-

nance. Objectives commonly shared by develop-ing countries include: more balanced and sym-metrical treatment of debtors and creditors regard-

ing codes, transparency andregulation; more stable ex-change rates among the majorreserve currencies; effectiveIMF surveillance of the poli-cies of the major industrialcountries, especially with re-spect to their effects on capi-tal flows, exchange rates andtrade flows of developing coun-tries; a less intrusive condi-tionality; and, above all, moredemocratic and participatorymultilateral institutions andprocesses. Effective reform ofthe international monetary andfinancial system will ultimate-

ly depend on the ability and willingness of devel-oping countries to combine their efforts aroundthese common objectives, and on acceptance bydeveloped countries that accommodating these ob-jectives is essential to building a more inclusivesystem of global economic governance.

Progress will depend on thewillingness of the majorindustrial countries toextend the reform agendaand process so that theyalso address the concernsof developing countries. Itwill depend no less onpositions taken bydeveloping countriesthemselves.

Notes

1 For a survey of these proposals, see TDR 1998, PartOne, chap. IV; Akyüz (2000a); and Rogoff (1999).

2 For a useful summary of the history, structure, func-tions and legal status of the BIS, see Edwards (1985:52–63). Until recently the principal shareholders ofthe BIS were 28 predominantly West European cen-tral banks, with those of Belgium, France, Germany,Italy and United Kingdom holding over 50 per centof the votes. The United States Federal Reserveparticipates in meetings and committees linked to

the BIS without being a shareholder. More recentlythe BIS invited additional central banks from emerg-ing markets to become shareholders.

3 Kaufman (1992: 57); and “Preventing the next glo-bal financial crisis”, Washington Post, 28 January2001, A.17. See also speaking notes by H. Kaufmanfor the Extraordinary Ministerial Meeting of theGroup of 24, Caracas, February 1998.

4 See also UNCTAD secretariat (1987), which reviewsthe experience with floating in the 1980s. In respect


of both the institutional hiatus and exchange ratebehaviour little has changed in the past 15 years.

5 This proposal was first made in Williamson (1983).6 Communiqué of the International Monetary and Fi-

nancial Committee of the Board of Governors ofthe International Monetary Fund, 24 September2000, Washington, DC: para. 11.

7 Horst Köhler, Address to the Board of Governors,Fifty-fifth Annual Meeting, Prague, 26 September2000.

8 See, for example, Wolf (2000); Eichengreen andPortes (2000); Summers (2000a); and also L.H. Sum-mers’ Testimony before the Banking Committee of

the House of Representatives, 23 March 2000; andGoldstein (2000). For similar proposals, see the ref-erences in Rogoff (1999).

9 The concept belongs to Gerald Corrigan, quoted inRogoff (1999: 27).

10 L.H. Summers, Testimony Before the Banking Com-mittee of the House of Representatives, 23 March2000: 14.

11 For an illuminating discussion of global governanceissues, see Helleiner (2000).

12 Paul Martin, Speech to the House of CommonsStanding Committee on Foreign Affairs and Inter-national Trade, Ottawa, 18 May 2000.

79Standards and Regulation

Many recent initiatives for international fi-nancial reform are directed at reaching agreementon, and implementation of, standards for majorareas of economic policy. Most of these standardsare ultimately intended to contribute to economicstability both at the national and internationallevel. Their main proximate targets are thestrengthening of domestic financial systems andthe promotion of international financial stability“… by facilitating better-informed lending and in-vestment decisions, improving market integrity,and reducing the risks of financial distress andcontagion” (FSF, 2000a, para. 23). In pursuit ofthese objectives, the standards cover not only thefinancial sector, but also aspects of macroeco-nomic policy and policy on disclosure. Manyfeatures of these standards reflect concerns aris-ing out of the experience of recent financial crises,though in a number of cases they also build oninitiatives involving mainly industrial countriesand originating from events of the more distantpast. While the standards themselves are designedto promote stability, their development can alsobe viewed as part of a process of arriving at a setof globally accepted rules for policy in the finan-cial and monetary spheres. Such rules couldfurnish one of the prerequisites for the provisionof international financial support for countries

experiencing currency crises. In this sense, theyare an international analogue of the national rulesfor the financial sector, compliance with which isa condition for lender-of-last-resort financing.

The Financial Stability Forum (FSF)1 hasidentified a number of standards which it consid-ers particularly relevant to strengthening financialsystems. These vary in the precise degree to whichthey have received international endorsement, butthey have been broadly accepted, in principle, asrepresenting basic requirements for good practice.As can be seen from table 4.1, the standards coverthe areas of macroeconomic policy and data trans-parency, institutional and market infrastructure,and financial regulation and supervision – areasthat are closely interrelated in many ways. Macro-economic policy, for example, can crucially affectthe more sectoral dimensions of financial stabil-ity through its impact on the values of financialfirms’ assets and liabilities (and thus on the con-text in which financial regulation and supervisionare conducted). It can also affect the functioningof the system for payments and settlement, whichis at the heart of the infrastructure of financialmarkets. Similarly, effective financial regulationand supervision are inextricably related to ac-counting, auditing and insolvency procedures.

Chapter IV

STANDARDS AND REGULATION

A. Introduction

80 Trade and Development Report, 2001

Insurance products are frequently incorporatedin, or sold in close conjunction with, investmentproducts, thus increasing the channels throughwhich disturbances affecting the market for onefinancial service can be transmitted to marketsfor another. And even such an apparently self-

contained issue as money laundering has, on oc-casion, threatened the stability of financial firms.2

The list of organizations associated with thekey standards in table 4.1 is not exhaustive, andthe standards themselves give only a brief idea of

Table 4.1

KEY STANDARDS FOR FINANCIAL SYSTEMS

Subject area Key standard Issuing body

Macroeconomic policy and data transparency

Monetary and financial Code of Good Practices on Transparency IMFpolicy transparency in Monetary and Financial Policies

Fiscal policy transparency Code of Good Practices in Fiscal Transparency IMF

Data dissemination Special Data Dissemination Standard (SDDS) IMFGeneral Data Dissemination System (GDDS)a

Institutional and market infrastructure

Insolvency Principles and Guidelines on Effective Insolvency Systemsb World Bank

Corporate governance Principles of Corporate Governance OECD

Accounting International Accounting Standards (IAS)c IASCd

Auditing International Standards on Auditing (ISA) IFACd

Payment and settlement Core Principles for Systemically Important Payment Systems CPSS

Market integrity The Forty Recommendations of the Financial Action FATFTask Force on Money Laundering

Financial regulation and supervision

Banking supervision Core Principles for Effective Banking Supervision BCBS

Securities regulation Objectives and Principles of Securities Regulation IOSCO

Insurance supervision Insurance Supervisory Principles IAIS

Source: FSF (2000a: 19).a Economies that have, or might seek, access to international capital markets are encouraged to subscribe to the more

stringent SDDS and all other economies are encouraged to adopt the GDDS.b The World Bank is coordinating a broad-based effort to develop these principles and guidelines. The United Nations

Commission on International Trade Law (UNCITRAL), which adopted the Model Law on Cross-Border Insolvency in1997, will help facilitate implementation.

c The BCBS has reviewed relevant IAS, and a joint BCBS-IASC group is further considering bank-related issues inspecific IAS. IOSCO has reviewed and recommended use of 30 IAS in cross-border listings and offerings, supplemented,where necessary, to address issues at a national or regional level. The IAIS’s review of relevant IAS is under way.

d The International Accounting Standards Committee (IASC) and the International Federation of Accountants (IFAC) aredistinct from other standard-setting bodies in that they are private sector bodies.


the many initiatives taking place under each head-ing. When the FSF reviewed the standards agendain March 2000, the 12 subject areas were alreadyonly a subset of a larger group which eventuallynumbered 64 (FSF, 2000a, paras. 55–57 and An-nex 8). The discussion in section B focuses on themain thrust and contents of the standards in ta-ble 4.1. It also aims to illustrate some omissionsand some of the practical problems posed by im-plementation of the standards. Section C looks atthe process of participation in the formulation andapplication of the standards initiatives. This leadsnaturally to the issue of bias in the official think-ing which underlies the selection of the subjectscovered by these initiatives and the asymmetricalway in which they are approached. To illustratethe strengths and weaknesses of this thinking,

section C examines in some detail three majorreports of FSF working groups. Section D dealsmore systematically with implementation issuesand some of the problems already raised in thecontext of particular standards in section B. Vari-ous incentives and sanctions are discussed as wellas the findings of a preliminary survey to reviewprogress so far. As discussed in section E, the con-tribution of standards to the achievement of greaterfinancial stability depends to a great extent on theirincorporation into the rules and norms of busi-ness practice. This in turn is closely connected tothe regulatory and supervisory regime withinwhich these rules and norms are applied. How-ever, improvements on this front have inherentlimits, as illustrated by examples taken from thekey area of banking supervision.

B. Themes of the key standards

Each of the codes discussed here is intendedto accomplish improvements at both macroeco-nomic and microeconomic levels. A significantpart of the impetus behind the initiatives discussedin subsections B.1–B.3 was furnished by particu-lar financial crises and systemic incidents of stress– mostly recent ones. Their major objectives aremacroeconomic or systemic, though particularfeatures of the behaviour of specific economicagents are also targeted. In the case of the codesdiscussed in subsections B.4–B.9, the balancebetween macroeconomic and microeconomicobjectives is different, with much less explicit em-phasis given to the former. Moreover, many of thelatter codes are of long-standing origin and ante-date the crises of the 1990s. It is their incorpora-tion into a global programme of financial reformthat is recent.

1. Macroeconomic policy and datatransparency

The Code of Good Practices on Transparencyin Monetary and Financial Policies (IMF, 2000c)identifies desirable transparency practices in theconduct of monetary policy and of policies to-wards the financial sector. These practices require:clarity with respect to the roles, responsibilitiesand objectives of central banks and financial agen-cies other than central banks with responsibilityfor overseeing and supervising different parts ofthe financial sector; open processes for the for-mulation and reporting of decisions on monetaryand financial policy; public availability of infor-mation concerning policies in both spheres; andaccountability and assurances of integrity for the


central bank, other financial agencies and theirstaff.

The Code of Good Practices on Fiscal Trans-parency (IMF, 1998a) is based on four principles:first, the roles and respon-sibilities of and within thegovernment should be trans-parent, and for this purposethere should be a clear legaland administrative frameworkfor fiscal management; sec-ondly, governments shouldcommit themselves to publicdisclosure of comprehensive,reliable information on fiscalactivities; thirdly, the processof budget preparation, execu-tion and reporting should beopen; and, fourthly, fiscal information should besubject to public and independent scrutiny.

The Special Data Dissemination Standardwas developed by the IMF in response to recog-nition, after the Mexican crisis, of widespreaddeficiencies in major categories of economic dataavailable. It prescribes the data which countriesintending to use the world’s capital markets shouldbe expected to make public concerning the real,fiscal, financial and external sectors of theireconomy. Moreover, it laysdown minimum benchmarksto be met in terms of periodic-ity and timeliness in the pro-vision of that information.Since its inception, the SpecialData Dissemination Standard(SDDS) has been strengthenedby the inclusion of a re-quirement to disclose notonly reserve assets, but alsoreserve-related liabilities andother potential drains on re-serves, such as short derivativepositions and guarantees ex-tended by the government forborrowing by the privatesector in foreign currency. The SDDS is sup-plemented by the General Data DisseminationSystem (GDDS), which is designed to improvethe quality of data disclosed by all member coun-tries of the IMF.

The rationale for these codes and standardshas several facets. The effectiveness of monetary,financial and fiscal policies can be enhanced ifthe objectives and instruments of policy in theseareas are known to the public and if the govern-

ment’s commitment to theseobjectives is credible. Goodgovernance more generally re-quires that central banks, otherfinancial agencies and fiscalauthorities are accountable.But an important aspect of theCodes’ rationale goes beyondtheir benefits at the domesticlevel and concerns interna-tional lenders and investors.Here, the idea is that transpar-ency should help lenders andinvestors to evaluate and price

risk more accurately, thus contributing to policydiscipline in recipient countries. Moreover, the as-sessment of individual countries made possible bythese Codes is expected to prevent the so-calledcontagion effect, whereby a loss of confidence inone country spreads to others simply because theybelong to the same category or region.3

That transparency regarding major areas ofmacroeconomic policy can contribute to theircredibility, and to good governance more gen-

erally, seems incontrovertible.Transparency is also capableof facilitating multilateralsurveillance by organizationssuch as the IMF. Understand-ably, the Codes confine them-selves to process rather thansubstance, since codes of rulesfor policy would be enor-mously complex if they wereto cover the great variety ofdifferent situations and coun-tries. In addition, it would bemuch more difficult to reachconsensus on such rules thanon those limited to process.

Regarding the expectation that either theCodes concerning macroeconomic policy or theSDDS will lead to much improved decisions byinternational lenders and investors, and thus to im-proved resource allocation and enhanced policy

The new disclosure rulesof the Special DataDissemination Standardfailed to serve as aneffective early warningsystem in the case of theAsian crisis.

A common characteristic ofthe countries affected byrecent financial crises wastheir openness to capitalflows, while there weresubstantial differences inmany of their macro-economic indicators andother features of theireconomies.


discipline for the governments of the receivingcountries, there are grounds for scepticism. Thenew disclosure rules of the SDDS failed to serveas an effective early warning system in the caseof the Asian crisis. Indeed, information was widelyavailable concerning the balance of payments ofthe countries involved, the external financial flowsto them, their corporate governance, trends in theirdomestic lending and in their banks’ exposure toovervalued property sectors, and major featuresof external assets and liabilities (though there weregaps in what was publicly disclosed concerningthe last of these items, gaps which subsequentstrengthening of the SDDS was designed to fill).And if the availability of pertinent data failed todeter capital flows associated with the build-upof eventually unsustainable external financialpositions in certain Asian countries, the sameapplied, a fortiori, to the behaviour of interna-tional lenders and investors in the RussianFederation prior to the crisis of mid-1998.

A more fundamental limitation of the poten-tial contribution of transparency to the preventionof financial instability is due to the considerablevariation in accompanying macroeconomic con-ditions and other features of policy regimes –a variation evident during recent financial crises.A common characteristic of the countries affectedby these crises was their openness to capital flows,but there were substantial differences in manyof their macroeconomic indicators and otherfeatures of their economies. These differences in-volved external deficits, the extent of currencyovervaluations, the size of budget deficits, the rela-tive importance of consumption and investmentin the booms preceding the crises, the relative sizeof countries’ external debt owed by the public andprivate sectors, and the coverage and effectivenessof regimes of financial regulation and supervision.

Analysis of recent international financial cri-ses also points to other difficulties as to the extentto which improved disclosure of macroeconomicvariables can contribute to greater financial stabil-ity, in particular to the avoidance of the contagioneffect. National balance sheets do not always re-flect the pressures on external payments that canresult from the adjustment of derivative positionswhich are off-balance-sheet and not always ad-equately covered by accounting rules. Moreover,derivative positions, even if covered under these

rules, are capable of blurring distinctions betweendifferent categories of exposure, such as thosebetween short and longer term. There is now aconsensus that cross-border hedging and otherpractices make many of the international finan-cial system’s fault lines difficult to identify inadvance. As a recent report of the Financial Stabil-ity Forum states:

Certain commonly employed risk manage-ment techniques … can have the effect ofadding to the volatility of both prices andflows in the international capital market …That is, investors acquire or dispose ofclaims whose risk characteristics and pricehistory resemble those of the asset beingproxied but where the market is deeper, moreliquid, or subject to fewer restrictions andcontrols. Such behaviour was one of the fac-tors behind the large fluctuations in capitalflows to South Africa and several countriesin Eastern Europe around the time of theAsian crisis. (FSF, 2000b, para. 28)

In the context of more recent events, atten-tion has been drawn to the way in which Brazilianbonds have become an instrument widely used byinvestors in emerging markets to hedge positionsin the debt of other countries such as the RussianFederation, Morocco and the Republic of Korea.

2. Banking supervision

Weaknesses in the banking sector and inad-equate banking supervision4 have played a centralrole in recent financial crises in developed as wellas developing countries. Recognition of the in-creasing potential for destabilizing the cross-border effects of banking crises – owing to theinternationalization of the banking business – hasled to initiatives since the 1970s that aim to im-prove international cooperation in banking regu-lation and supervision. Initially, these initiativeswere directed primarily at banks in industrialcountries and offshore financial centres in re-sponse to a number of events that highlighted theinadequacies in their banking regulation andsupervision. These events provided much of theinspiration for subsequent efforts to improve regu-latory and supervisory cooperation. The standardswhich emerged from these initiatives eventually


also achieved widespread acceptance among de-veloping and transition economies. The BaselCommittee on Banking Supervision (BCBS) – themost important vehicle for most of these initia-tives – has increasingly assumed the role of glo-bal standard-setter in this area.5

A major outcome of the BCBS’s extensionof the focus of its activities beyond the concernsof its member countries is the Core Principles forEffective Banking Supervision issued in late 1997.In the development of these Principles, the BCBScollaborated with supervisors of economies out-side the Group of Ten (includ-ing several developing andtransition economies). Theycover seven major subject ar-eas: (i) the preconditions foreffective banking supervision;(ii) the licensing and structureof banks; (iii) prudential re-gulations and requirements;(iv) methods of ongoing su-pervision; (v) information re-quirements; (vi) the formalpowers of supervisors; and (vii) cross-borderbanking. In April 1998, the BCBS undertook asurvey of compliance with the Core Principles in140 economies, an effort paralleled by IMF andWorld Bank reviews of compliance in selectedcountries.6 Subsequently a Core Principles Liai-son Group (CPLG) of 22 members7 was set up toprovide feedback to the BCBS on the practical im-plementation of these Principles. The reviews ofcompliance and feedback from the CPLG led tothe development by the BCBS of the Core Princi-ples Methodology issued in October 1999 (BCBS,1999a).

This document on methodology is intendedto provide guidance in the form of “essential” and“additional” criteria for the assessment of com-pliance by the different parties to which this taskmay be entrusted, such as the IMF, the WorldBank, regional supervisory groups, regional de-velopment banks and consulting firms, but not theBCBS itself. In addition to the specific criteriarelating to banking supervision, the assessors arealso required to form a view as to the presence ofcertain more general preconditions regarding suchsubjects as: (i) sound, sustainable macroeconomicpolicies; (ii) a well developed public infrastruc-

ture, including an adequate body of law covering,for example, contracts, bankruptcy, collateral andloan recovery, as well as accounting standardsapproaching those of international best practices;(iii) market discipline based on financial transpar-ency, effective corporate governance and theabsence of government intervention in banks’commercial decisions except in accordance withdisclosed policies and guidelines; (iv) adequatesupervisory procedures for dealing with problemsin banks; and (v) adequate mechanisms for sys-temic protection such as a lender-of-last-resortfacility or deposit insurance (or both). The parts

of the assessment directedmore specifically at bankingsupervision comprise not onlythe procedures of supervisionbut also its subject matter(which, of course, includesthe standards for prudentialregulation and for banks’own internal controls and riskmanagement covered in theBCBS’s own documents overthe years). With respect to

subjects such as accounting and auditing stand-ards and insolvency law, the Core Principles forEffective Banking Supervision clearly overlap tosome degree other key standards mentioned intable 4.1.

Assessment of compliance with the CorePrinciples requires evaluation of several relatedrequirements, including prudential regulation andother aspects of the legal framework, supervisoryguidelines, on-site examinations and off-siteanalysis, supervisory reporting and other aspectsof public disclosure, and enforcement or itsabsence. Assessment is also required of the super-visory authority’s skills, resources and commit-ment, and of its actual implementation of the CorePrinciples. If evaluation of the preconditions foreffective supervision (mentioned earlier) and as-sessment of the criteria relating to supervision it-self are considered together, the exercise coverssubstantial parts of a country’s commercial law,its accounting and auditing standards, and to someextent the quality of its government’s macroeco-nomic management.

The assessment of relevant laws, regulationsand supervisory procedures would appear to be

Internationally promulgatedstandards can help upgradenational rules and norms,but the objective should notbe uniform rules for allcountries.


fairly straightforward, but that of supervisory ca-pacity and the effectiveness of implementationmore complex.8 Thus, perhaps understandably, theannex to the Core Principles Methodology, whichsets out the structure and methodology for assess-ment reports prepared by the IMF and the WorldBank, focuses principally on the former set of sub-jects and not the latter. Assessment of supervisorycapacity and the effectiveness of implementationis generally likely to be feasible only through ex-tended in-depth scrutiny. This would require alengthy presence of the assessor in the countryundergoing assessment, either in the form of apermanent presence, or through a process involv-ing several visits. If the latter option were selectedfor the purpose (and it seems rather more likelyto be acceptable and more in accord with normalprocedures for IMF surveillance), an authoritativeassessment of compliance with the Core Princi-ples may take years.

Assessment of the more general precondi-tions for effective supervision is not mentionedin the annex to the Core Principles Methodology,but here, too, a lengthy exercise is likely to benecessary. In particular, assessment of the manydimensions of a country’s legal regime and of itsaccounting and auditing standards requires evalu-ation not only of laws, regulations and principlespromulgated by professional bodies (such as thoseof accountants), but also of their implementation,and of the way in which they are incorporated intorules and norms in practice.9 Many features ofcountries’ legal regimes and business norms reflectdifferences in historical roots and in compromisesamong social groups. Internationally promulgatedstandards can help upgrade national rules andnorms, but many aspects of the process will begradual, and the objective should not be uniformrules for all countries.10

At the level of the countries being assessed,such exercises will often place an additional bur-den on a limited supply of supervisory capacity.In time, this capacity can be expanded, but thetraining of a bank supervisor typically requiresa considerable period. And once trained, a super-visor may be faced with attractive alternativeemployment opportunities in the private sector,or even in the IMF or the World Bank themselves(which have recently been increasing the numberof their staff with expertise in this area). There is,

of course, awareness of the problem of humanresources among bodies such as the BCBS, theIMF, the World Bank and the CPLG, and effortsare being made to coordinate initiatives and toensure that scarce expert resources are used in themost efficient way. However, there remains a realdanger that international assessment of countries’supervision will be at the expense of actual su-pervision on the ground.

3. Payments and settlement

Payment systems enable the transfer of fundsbetween financial institutions on their own behalfand on behalf of their customers, a role whichmakes such systems a potential source of systemicrisk. This role is evident from a consideration offour key dimensions of an economy’s flow-of-fundsprocess: (i) the activities of various economicagents; (ii) the markets for financial instruments,assets and liabilities; (iii) the supporting infra-structure, of which an integral component is thepayments system; and (iv) economic conditionsbinding the markets together and ensuring thatthey clear. Failures in any of the first three di-mensions are capable of disrupting links betweenthe markets and between economic agents whosemutual interdependence is based on several dif-ferent kinds of transaction and exposure. If large,such disruptions can easily take on a systemiccharacter.11 Moreover, payment systems also playan essential role in foreign exchange transactions,which are thus an interface between differentcountries’ payment systems.12 As a result of thelinks and similarities between systems of paymentand settlement for fund transfers and for transac-tions in other financial assets, the main vehiclefor international initiatives in this area, the BISCommittee on Payment and Settlement Systems(CPSS), has extended its purview beyond fundtransfers to settlement systems for securities andforeign exchange and to clearing arrangements forexchange-traded derivatives (White, 1998:196–198). Moreover, the specific stability issues posedby securities settlement are currently the subjectof a joint working group of the CPSS and theInternational Organization of Securities Commis-sions (IOSCO).13 But the discussion here will be


limited to the key standard in the area of paymentand settlement mentioned in table 4.1.

The initiative to develop an internationallyagreed framework of core principles for the design,operation and oversight of payment and settlementsystems reflects increased recognition of the risksassociated with rapidly rising volumes of pay-ments (CPSS, 2000a).14 The main risks in thesesystems are: credit risk, when a counterparty isunable to meet obligations within the system cur-rently or in future; liquidity risk (clearly closelyrelated, but not identical, to credit risk), when acounterparty has insufficient funds to meet obli-gations within the system, though it may be ableto do so at some future time; legal risk, when aninadequate legal framework or legal uncertaintiescause or exacerbate credit or liquidity risks; andoperational risk, when factors such as technicalmalfunctions or operational mistakes cause orexacerbate credit or liquidity risks. As discussedabove, any of these risks can have systemic con-sequences, as the inability of a counterparty orcounterparties to meet obligations within the sys-tem can have a domino effect on the ability ofother counterparties to meet their obligations,and thus, ultimately, threaten the stability of thefinancial sector as a whole.15 The task force es-tablished to develop the Core Principles was tolimit itself to “systemically important paymentsystems”, namely those capable of triggering ortransmitting shocks across domestic and interna-tional financial markets.

The first Core Principle is directed at legalrisk and specifies the need for a robust legal basisfor the payment system, a requirement that linksits rules and procedures to related areas of lawsuch as those concerning banking, contract andinsolvency. The second and third Principles con-cern rules and procedures for enabling participantsto have a clear understanding of the system’s im-pact on financial risks. They also recognize theneed for defining how credit and liquidity risksare to be managed and for identifying responsi-bilities for this purpose. A system’s risks can beexacerbated by the length of time required forfinal settlement or by the nature of the asset usedto settle claims. Thus the fourth and sixth Princi-ples specify the need for prompt settlement andfor a settlement asset that is either a claim on thecentral bank or one carrying little or no credit risk

(owing to the negligible risk of its issuer’s fail-ure). The fifth Principle requires a minimumstandard of robustness for multilateral nettingsystems.16 The seventh Principle is intended tominimize operational risk through ensuring a highdegree of security and operational reliability. Theeighth, ninth and tenth Principles address the moregeneral issues of the system’s efficiency and prac-ticality (including the need for explicit recognitionof any trade-off between safety and efficiency).They also address the need for objective and pub-licly disclosed criteria for participation in thesystem, permitting fair and open access, and ef-fective, accountable and transparent governancearrangements. The Core Principles attribute tocentral banks key responsibility for ensuring thatpayment systems comply with the Principles.

The second part of the Report on the CorePrinciples for Systemically Important PaymentSystems provides details on issues such as the iden-tification of systemically important paymentsystems, the modalities of their review and reform,structural, technical and institutional factors to beconsidered, and the kinds of cooperation neces-sary with participants in the system, user groupsand other parties to the reform process (CPSS,2000b).17 The second part also takes up certaincross-border aspects of payment systems. TheCore Principles are now included in the jointIMF-World Bank Financial Sector AssessmentProgramme (FSAP).18 However, experience in in-dustrial countries suggests that the upgrading ofpayment systems required by the Principles islikely to entail a lengthy process owing to themany different actions required and the many dif-ferent parties involved.

4. Accounting and auditing

Improvements in financial reporting andtransparency are essential to most of the initia-tives on codes and principles, but in the area ofaccounting and auditing in table 4.1 there is anexplicit aim to harmonize standards. Through theirimpact on disclosure, these standards have an ob-vious bearing on counterparties’ ability to assessthe financial risks of transactions. The need forinternational harmonization is also due to the


growth in cross-border business, especially inlending and investment. The principal body withresponsibility for promulgating international ac-counting standards is the International AccountingStandards Committee (IASC).19

Much of the recent work of theIASC has been directed atreaching a compromise on aset of standards acceptableboth to the United States andto other member countries,and which satisfies disclosurerequirements for the issuanceand trading of securities in theworld’s major financial mar-kets. A number of the difficult problems here con-cerns the reconciliation of the understandablypluralistic approach of the IASC with the morespecific and constraining rules of the GenerallyAccepted Accounting Principles (GAAP) of theUnited States.20

While debate on the International Account-ing Standards (IAS) is concerned mainly withhighly specific subjects,21 its impact on the inter-national financial system is likely to depend moreon its success in raising standards of accountingand financial reporting worldwide. And this willalso be related to accompanying initiatives to raiseauditing standards. The targets of such efforts in-clude internal auditing (i.e. as-sessment of the extent and ef-fectiveness of a firm’s man-agement and accounting con-trols and of the safeguardingand efficient use of its assets)as well as external auditing(i.e. auditing of financial state-ments and supporting evi-dence to determine the con-formity of the former with ap-plicable standards). Internalauditing is now a legal require-ment in several countries, and auditing commit-tees have frequently acquired greater importancein countries where shifts in corporate governancehave resulted in increased power for boards of di-rectors vis-à-vis senior operating executives. Butit is external auditing which is the principal sub-ject of international initiatives. Here the problemsof harmonization relate partly to differences in theaccounting standards underlying financial state-

ments but also to divergences in audit standard-setting processes themselves. These divergencesresult, for example, from the fact that in somecountries auditing standards are set by the ac-

counting profession whereasin others they are based on re-quirements mandated in lawsand regulations, or they resultfrom a process involving thejoint participation of both theaccounting profession and thegovernment. The institutionspecified in table 4.1 as hav-ing the lead responsibility forinternational harmonization of

auditing standards is the International Federationof Accountants (IFAC),22 which closely collabo-rates with other bodies also occupying key posi-tions in this area such as IOSCO and relevantEU institutions.

While improved standards of accounting andauditing have the potential for contributing to bet-ter decision-making by lenders and investorsthrough enhanced transparency, recent experiencecautions against exaggerated expectations in thisregard, especially in the short run. There is also aquestion as to how far the greater transparency –which is the main ultimate objective under thisheading – leads to greater financial stability. As the

celebrated investment manager,Warren Buffett, warns, “the ac-countants’ job is to record, notto evaluate”, and “… the busi-ness world is simply too com-plex for a single set of rules toeffectively describe reality forall enterprises” (Cunningham,2000: 196, 202). In the case offinancial firms, the difficultiesare multiplied by the speedwith which assets and liabili-ties can change, even in cases

where high standards of reporting are observed.Moreover, as already noted, although financial re-porting was poor in several of the countries in-volved in recent financial crises, there was noshortage of information available to lenders andinvestors about key macroeconomic variables andthe general economic and legal environment in thecountries concerned. And if the information ingood financial reporting has such a beneficial ef-

There is also a question asto how far the greatertransparency leads togreater financial stability.

If the information in goodfinancial reporting has sucha beneficial effect ondecision-making, why werelenders and investors notmore wary in its absence?


fect on decision-making, why were lenders andinvestors not more wary in its absence, especiallyin view of weaknesses which should have beenevident from the macroeconomic informationwhich was available?

5. Corporate governance

Corporate governance involves the relation-ships between the management of a business andits board of directors, its shareholders and lend-ers, and its other stakeholders such as employees,customers, suppliers and the community of whichit is a part. The subject thusconcerns the framework inwhich the business objectivesare set and how the means ofattaining them and otherwisemonitoring performance aredetermined. The OECD Prin-ciples of Corporate Govern-ance (OECD, 1999) cover fivebasic subjects: (i) Protectionof the rights of shareholders,a heading that includes allow-ing the market for corporatecontrol to function efficiently,transparently and fairly for allshareholders; (ii) Equitabletreatment of shareholders, in-cluding minority and foreign shareholders, withfull disclosure of material information and the pro-hibition of abusive self-dealing and insider trad-ing; (iii) Recognition and protection of the exer-cise of the rights of stakeholders as establishedby law, and encouragement of cooperation be-tween corporations and stakeholders in creatingwealth, jobs and financially sound enterprises;(iv) Timely and accurate disclosure and transpar-ency with respect to matters relevant to companyperformance, ownership and governance, whichshould include an annual audit conducted by anindependent auditor; and (v) A framework of cor-porate governance to ensure strategic guidance forthe company and effective monitoring of its man-agement by the board of directors, as well as theboard’s accountability to the company and share-holders (certain key functions of the board beingspecified under this heading).

Corporate governance sets rules on matterswhere variations of approach among countries areoften rooted in societal differences – for exam-ple, with respect to the relative importance offamily-owned firms as opposed to corporations,or to prevalent norms regarding the primacy ofsometimes conflicting business objectives, suchas long-term sustainability, on the one hand, andvalue for shareholders, on the other. These societaldifferences, in turn, generally reflect differencesin national histories and in the political and socialconsensus which has grown out of them.23 Thepreamble to the OECD Principles acknowledgesthat there is no single model of good corporategovernance and the Principles themselves arefairly general. They avoid rules for the more con-

tentious aspects of relationsbetween companies and theirlenders and investors, such asappropriate levels of leverage.They also avoid the more de-tailed rules for the market forcorporate control. Neverthe-less, there remains a dangerthat the technical assistanceand assessment exercises as-sociated with the promulgationof these Principles – whichwill also involve other organi-zations such as the World Bank– will contain features that re-flect biases in favour of conceptslinked to particular models of

corporate governance, most notably those of theUnited Kingdom or the United States.

Regarding the potential of better corporategovernance to contribute to financial stability, aconclusion similar to that for auditing and account-ing seems in order. Improvements in this area canbe expected to lead to better decision-making onseveral matters, but if they are based on princi-ples similar to those enunciated by the OECD, theyare likely to be gradual. Moreover, the better de-cision-making achieved in this way may have onlylimited effects on instability, which results fromforces which corporate governance can mitigatebut not eliminate. These forces include the pres-sures on loan officers to achieve target levels ofprofit in financial firms (a chronic problem, butone still not satisfactorily addressed in most firms’internal controls), weakness in even state-of-the-

Corporate governance setsrules on matters wherevariations of approachamong countries are oftenrooted in societal differencesthat generally reflectdifferences in nationalhistories and in the politicaland social consensus whichhas grown out of them.


art techniques for controlling credit, market andother financial risks, and psychological factorsconducive to imitative and herd behaviour in thefinancial sector.

6. Insolvency

Insolvency rules are such a substantial partof corporate governance as defined above that theyhave generated a separate literature on the subject.There is general recognition that existing regimesfor insolvency are characterized by widespreadweaknesses, or indeed by their total absence insome situations and countries.24 At the nationallevel (particularly in many developing and tran-sition economies), weakness isassociated with problems re-garding the enforcement ofcontracts, ineffective modal-ities for the netting, clearanceand settlement of outstandingobligations, poorly function-ing arrangements for the col-lateral and security of loans,and conflicts of law. All thesefeatures can pose serious prob-lems for certain aspects of thevaluation of firms and securi-ties, and they can be a source of increased financialrisk. Their presence in emerging markets can there-fore be a significant deterrent to foreign investment.

The lead role in developing globally accept-able rules for insolvency has been attributed tothe World Bank, whose objective is to develop an“integrated matrix” of components and criteria forsuch rules, highlighting existing best practices.25

These elements are intended to be a complementof a country’s legal and commercial system withguidance provided as to how they would interactwith and affect the system. Consensus on them isto be developed through a series of assessmentexercises and international insolvency symposia.The principal focus of the World Bank’s initiativeis national regimes in developing and transitioneconomies.

The feedback from this process has led to aConsultation Draft organized into the following

three parts: (i) legal, institutional, regulatory, andrestructuring and rehabilitation building blocks;(ii) different categories of insolvency conditionssuch as systemic insolvency and that of banks andenterprises; and (iii) an international dimensionconcerned with encouraging developing andtransition economies to take account of bothinternational best practices and issues with a cross-border dimension in order to facilitate their accessto international financial markets.

Improved insolvency rules have a more di-rect link to financial stability than many of theother subjects covered by the codes in table 4.1.Their main role under this heading is to help con-tain the problems due to the insolvencies of par-ticular firms and to prevent broader contagioneffects. The beneficial impact of this role obvi-

ously extends to cross-borderlending and investment. How-ever, as noted above, the fo-cus of the initiative being ledby the World Bank is on rulesfor developing and transitioneconomies, even though cross-border insolvencies (i.e. insol-vencies involving firms withbusiness entities in more thanone country) pose difficultproblems of coordination andconflicts of law in developed

countries as well. Here the danger is that the in-solvency of a large firm with an extensive inter-national network of entities could seriously disruptcross-border transactions. A special threat is thatposed by the possibility of the failure of a largemultinational bank having a home jurisdiction ina developed country.26 Most of the problems whichwould result from such a failure concern the cross-border dimensions of insolvency, and attempts todevelop international rules are currently concen-trated in other forums.27

7. Securities regulation

The Objectives and Principles of SecuritiesRegulation, published by IOSCO in September1998, sets out three major objectives: the protec-tion of investors; ensuring that markets are fair,

The insolvency of a largefirm with an extensiveinternational network ofentities could seriouslydisrupt cross-bordertransactions.


efficient and transparent; and the reduction of sys-temic risk. To achieve these objectives, it lists 30principles covering responsibilities of the regula-tor, self-regulation, enforcement of securitiesregulation, cooperation in regulation domesticallyand internationally, the responsibilities of issuers,rules and standards for collective investmentschemes, requirements for market intermediaries,and rules and standards for the secondary market.The principles explicitly related to systemic riskare covered mainly under the last two headings,and are concerned with capital and prudentialstandards for market intermediaries, proceduresfor dealing with the failure of a market interme-diary, and systems for clearing and settlingsecurities transactions which minimize such risk.In other words, the focus of the principles for re-ducing systemic risk is on measures directed atfirms and market infrastructure.

Unsurprisingly for a code produced by a glo-bal organization of specialist regulators, theseprinciples are concerned mainly with the fairnessand efficient functioning of markets themselves.Connections to broader issues of macroeconomicpolicy and to policy towards the financial sector,both of which have been associated with systemicinstability in developing and transition economies,are ignored. A more comprehensive and repre-sentative set of principles for securities markets –including issues highlighted by recent crises indeveloping and transition economies – should ar-guably address some aspects of policy towards thecapital account of the balance of payments (suchas appropriate conditions for the access of foreignportfolio investors) and the commercial presenceof foreign investment institutions.

8. Insurance

Traditionally, insurance is not regarded as asource of systemic risk. Consequently, the princi-pal objectives of its regulation and supervision areclient protection and the closely related subjectsof the safety and soundness of insurance compa-nies and their proper conduct of business. Thisinvolves such matters as disclosure, honesty, in-tegrity and competence of firms and employees,marketing practices, and the objectivity of advice

to customers. The principal grounds for down-playing the systemic risks of the insurance sectorare that companies’ liabilities are long term andnot prone to runs, while their assets are typicallyliquid. Moreover, mutual linkages among insur-ance companies and linkages between suchcompanies and other financial firms are limitedowing to the lack of a role for the former in clear-ing and payments and to the extent and depthof the markets where their assets are traded(Goodhart et al., 1998:14).

However, recently questions have been raisedas to the adequacy of this characterization. Thisis partly due to the expanding role of the insur-ance sector in savings and investment productsstemming from the close links between manykinds of life insurance policy and personal savingor investment instruments. The recent expansionin its turn is due partly to trends in the conglom-eration of financial firms that have witnessed morewidespread involvement of insurance companiesin the sale and management of investment funds,on the one hand, and of banks in the insurancebusiness, on the other. These trends have increasedthe possibility of contagion between insurance andother forms of financial business and, where largefirms are involved, the scale of the possible ad-verse consequences of such contagion. In the caseof developing and transition economies, an addi-tional danger should be taken into account,namely, that the failure of one or more financialfirms – including those with substantial insuranceinterests – may trigger a run on the currency. Theresulting depreciation can have adverse conse-quences extending well beyond the sector wherethe problems originate.

The focus of the Insurance Core Principles28

is the organization and practice of the sector’ssupervision, as well as the following sector-specific subjects: the corporate governance ofinsurance companies, their internal controls, pru-dential rules, conduct-of-business issues and thesupervision of cross-border business. The pruden-tial rules cover the management of an insurancecompany’s assets, the identification and classifi-cation of liabilities, rules for capital requirementsand for the use, disclosure and monitoring of de-rivatives and other off-balance-sheet items, andreinsurance as an instrument for risk containment.The principle covering the supervision of cross-


border business operations is designed to ensurethat no cross-border insurance entity escapes su-pervision, and that adequate arrangements are inplace for consultations and information exchangebetween such an entity’s home-country andhost-country supervisors. Thus the focus of theInsurance Core Principles is functional, while is-sues explicitly relating to the supervision offinancial conglomerates are left to other forums(IAIS, 2000a).29

9. Market integrity and money laundering

Money laundering is one of the most politi-cally sensitive subjects covered by the codes andprinciples listed in table 4.1. It is an area wherefinancial supervision interfaces directly with lawenforcement – including some of the latter’stougher manifestations – since the activities fi-nanced with laundered money include drugdealing and terrorism. Indeed, the attention givento money laundering reflects, to a significant ex-tent, the political difficulties in major developedcountries in dealing with the problem of drugconsumption. The policies adopted here have fo-cused mainly on repression ofproduction and consumptionas opposed to alternative ap-proaches, with the result thatprofits from illegal supply re-main high. Money launderingis also closely connected tocorrupt activities in developedand developing countries sinceit is used for concealing thesize, sources and recipients ofthe money involved in suchactivities. Generally acceptedestimates of the global scale ofmoney laundering do not yet ex-ist, but there is no doubt that it is very large. Moneylaundering has long been an important issue in rela-tions between OECD countries and offshorefinancial centres. However, some recent scandalsindicate that it also remains a problem for coun-tries with traditional financial centres.30

The principal international body entrustedwith the task of combating money laundering is

the Financial Action Task Force on Money Laun-dering (FATF),31 established after the Group ofSeven summit in 1989. Its current membershipconsists of 29 (mainly developed) countries andtwo international organizations – the EuropeanCommission and the Gulf Cooperation Council.In 1990, the FATF drew up a list of 40 recom-mendations which members are expected to adopt.These were revised in 1996 to take account of ex-perience gained in the meantime and of changesin money laundering practices (FATF, 1999). Im-plementation by member countries of theserecommendations is monitored on the basis of atwo-pronged approach – an annual self-assessmentexercise and periodic peer reviews of a membercountry by teams drawn from other members.More recently, the FATF has also conducted anexercise to identify jurisdictions deemed to benon-cooperative in the combat against moneylaundering (FATF, 2000). It clearly hopes thatidentification and the attendant publicity willprompt improvements in the 15 countries it hasidentified so far. In addition, its members haveagreed to issue advisories to regulated financialinstitutions within their jurisdictions, requiringthem to take extra care in business undertaken withcounterparties in the 15 countries – an action thatis likely to impose extra costs on such business.

The FATF’s 40 recom-mendations include the fol-lowing obligations: criminal-ization of the laundering of theproceeds of serious crimes; theidentification of all customersand the keeping of appropri-ate records; a requirement thatfinancial institutions reportsuspicious transactions to thecompetent national authorityand that they develop pro-grammes to counter moneylaundering, including compre-

hensive internal controls and employee training;adequate supervision of money laundering and thesharing of expertise by supervisors with other do-mestic judicial and law enforcement authorities;and the strengthening of international cooperationthrough information exchange, mutual legal as-sistance and bilateral and multilateral agreements.There are relations between the FATF’s initiativesand others directed at offshore financial centres.32

Money laundering has longbeen an important issue inrelations between OECDcountries and offshorefinancial centres. However,some recent scandalsindicate that it also remainsa problem for countries withtraditional financial centres.


For example, the harmful tax competition tech-niques for evading tax through recourse to off-shore financial centres that are the subject of theOECD initiative (OECD, 2000d) are often the sameas or similar to those used in money laundering.Likewise, “know your client” rules – a standardpart of an effective regime for financial regulation– generally cover much the same ground as theFATF’s requirements concerning customer iden-tification. However, as in the case of other codesand principles discussed in this section, the con-tributions of the FATF’s recommendations to in-ternational financial stability are mostly indirect.

Disclosures about involvement in moneylaundering have sometimes been associated with

C. Influence and participation in the formulationand implementation of standards

the failure of financial firms. However, moneylaundering – like the facilities offered by offshorecentres – has played, at most, a marginal role inrecent financial crises. Nevertheless, by makingcertain types of capital flight more difficult orcostly, better control of money laundering can helprestrain certain potentially destabilizing capitalflows and accumulation of external debt not linkedto legitimate economic activity. But the effective-ness of such restraint will depend on the degreeof active cooperation between countries which aresources and recipients of laundered money. Ruleson money laundering are therefore an essentialcomponent of regulatory regimes for financialfirms; without them such regimes could scarcelybe characterized as effective or comprehensive.

Since standards became an integral compo-nent of international financial reform, muchemphasis has been placed on the importance of“ownership” of their adoption and implementationby the countries affected. Extensive consultationhas taken place as part of the assessment of im-plementation now under way and the results caneventually be expected to affect the future devel-opment of the standards themselves. However, notall of the exercises under this heading have beenfree of asymmetries among the different partiesinvolved. This has led, on occasion, to questionsabout fairness. Lack of symmetry, particularly inthe degree to which developing countries’ con-cerns are taken into account, is also evident in theselection of subjects to which some of the stand-ards are to apply. This would appear, at least partly,to reflect divergences in viewpoints concerningthe functioning of the international financial sys-tem and the issues appropriate for policy action.

“Ownership” is related to countries’ percep-tions of their national interest in the adoption andimplementation of standards. Such perceptions canbe assisted by the exchange of experiences in fo-rums such as the multilateral financial institutionsand the standards-setting bodies, providing theopportunity to contribute to standards setting,alignment of programmes for standards implemen-tation with domestic agendas for financial reform,and encouraging and aiding self-assessment (FSF,2000a: 2). The promotion of country ownershipis an objective of outreach programmes on stand-ards implementation (IMF, 2000e), which operatethrough vehicles such as technical assistance,workshops and regional meetings. These act-ivities have also involved the IMF and the WorldBank, institutions with relevant expertise suchas supervisors from major industrial countries,and others participating in processes of peer re-view.


The asymmetries mentioned above are notomnipresent and are not always easily identified,since they are often woven into basic assumptionsor categories underlying the standards in table 4.1.The bias in some of the Codes towards subjectslikely to be of greater concern to developed coun-tries often reflects the historical origins of theinitiatives in question. Much of the cross-borderbusiness affecting the subjects covered was tradi-tionally between parties in industrial countries,with developing countries’ involvement beingonly fairly recent. Yet despite their increasingprominence in this context, certain concerns ofdeveloping countries appearto have been set aside duringstandards formulation andtheir interests ignored or down-played during the follow-up.Moreover, parts of policy docu-ments, the issuance of whichhas coincided with the stand-ards initiatives – and whichtreat important parts of theirrationale – in some cases sub-stantially reflect official view-points in major developedcountries, as evident from re-cent reports of the FSF.

For example, the report of the FSF’s WorkingGroup on Capital Flows (FSF, 2000b) focuses mainlyon improved risk-management practices and en-hanced transparency on the part of private andpublic sectors in countries receiving internationallending and investment as the principal means ofcountering the instability of these flows.33 The re-port also identifies various biases or incentives inthe policies of recipient countries that are likelyto lead to excessive dependence on short-term (andthus potentially volatile) inflows. But it downplaysthe impact of the behaviour of lenders and inves-tors in developed countries as well as the effectsof macroeconomic policies in these countries oncapital flows to developing and transition econo-mies. The report gives considerable attention toimprovements in the provision and use of officialstatistics and of information in financial report-ing by the private sector in recipient countries.However, it shies away from endorsing a require-ment for frequent disclosure of data on the largeshort-term positions in assets denominated in acountry’s currency held by foreign firms other than

banks (a category that includes hedge funds),which several developing (and some developed)countries perceive as threats to the stability of theirexchange rates and financial markets.

Similarly, the report of the FSF Working Groupon Highly Leveraged Institutions (HLIs)34 hastended to play down widely expressed concernsof certain countries in some of its policy recom-mendations (FSF, 2000c). This Working Groupdistinguished between two broad groups of issuesposed by HLIs: systemic risks (of the kind exem-plified by the collapse of Long Term Capital Man-

agement (LTCM)), on the onehand, and “market dynamicsissues” (i.e. the amplificationof instability and the threats tomarket integrity which mayresult from HLIs’ operationsin “small- and medium-sizedopen” economies), on the oth-er. The systemic risks whichmay be caused by HLIs arenaturally of concern to devel-oping and transition econo-mies. Like other participantsin international financial mar-kets, for example, they were

affected by the increases in risk premiums and thesharply reduced availability of financing in late1998, to which the collapse of LTCM contributed.Nevertheless, their special concerns are relatedmore to the “market dynamics issues”.

The Working Group conducted an exami-nation of “market dynamics issues” in the ex-periences of six economies during 1998.35 Itsconclusions amounted to a qualified endorsementof concerns which had been expressed regardingHLIs. Thus the capacity of HLIs to establish largeand concentrated positions in small- and medium-sized markets was acknowledged, and with this,their potential to exert a destabilizing influence.But there was less consensus as to the importanceof their influence in comparison with other fac-tors during particular instances of instability inthe different economies during 1998. Similar con-clusions were reached regarding the threat tomarket integrity posed by some aggressive prac-tices attributed to HLIs, such as heavy selling ofcurrencies in illiquid markets, dissemination ofrumours about future developments, selective dis-

Certain concerns ofdeveloping countriesappear to have been setaside during standardsformulation and theirinterests ignored ordownplayed during thefollow-up.


closure of information about firms’ positions andstrategies, and correlated position-taking in themarkets for different assets within a country andalso across currencies with the objective of achiev-ing profitable movements in relative prices.36 Here,too, the capacity of HLIs to engage in such prac-tices was recognized, but there was less agreementas to its significance at different times and in dif-ferent countries.

The major thrust of the Working Group’srecommendations is directed at reducing the sys-temic risk HLIs are capable of causing rather thanat “market dynamics issues”. The recommenda-tions, directed primarily at systemic risk, havemany connections to those of official bodies andindustry groups of major industrial countries sur-veyed at some length in an annex to the report.These include: stronger risk management by bothHLIs and their counterparties; enhanced regula-tory oversight of HLIs’ credit providers; furtherprogress in industry practices with regard to suchaspects as the measurement of exposures and ofliquidity risk, stress testing, collateral managementand external valuation, as well as in buildingmarket infrastructure in areas such as the harmo-nization of documentation, valuation and bank-ruptcy practices. In addition, the Working Grouprecommended fuller public disclosures by HLIsin the context of a movement towards improvedand more comparable risk-based public disclosureby financial institutions more generally.

Most of these recommendations are capableof having beneficial effects on “market dynamicsissues” and of reducing systemic risk. However,the Working Group limited itself to two recom-mendations of particular relevance to the formersubject. The first recommendation aims at strength-ening some kinds of surveillance of activity infinancial markets at the national level with a viewto identifying rising leverage and other concernsrelating to market dynamics that may requirepreventive measures. The second aims to promoteguidelines of good practice for currency tradingwith the support of leading market participantswho would review and, as necessary, revise existingcodes and guidelines in this area in the light of con-cerns recently expressed about trading behaviour.

Underlying the second of these two recom-mendations is a recognition of the absence in most

emerging financial markets of guidelines andcodes of conduct for trading practices, such as areissued in most major financial centres by tradeassociations, industry groups and committees ofmarket participants. The recommendation is thatmajor financial institutions should take the ini-tiative in preparing and promoting codes andguidelines for jurisdictions where they currentlydo not exist. If this recommendation is to be effec-tive, it must not only lead to industry initiativesof the kind envisaged, but also to changes in ac-tual behaviour, even though such guidelines andcodes lack legal weight.

Regarding surveillance and transparency con-cerning market positions, the report on HLIs ismore forthcoming than that on capital flows,though the somewhat veiled character of the ex-position renders the nature of the different optionsconsidered, and the Group’s view on their associ-ated pros and cons, hard to grasp precisely. Thecollection of aggregate high-frequency informa-tion on positions in key markets is not acceptedon the grounds of feasibility, cost and difficultiesin obtaining compliance.37 National initiatives in-volving proactive surveillance between monetaryauthorities, supervisors and market participants re-ceive greater support from the Working Group,but subject to reservations and doubts concerningsuch matters as the costs and benefits of, and in-ternational participation needed for, disclosure ofinformation on positions in major emerging-mar-ket currencies. Some surveillance of this kind (butpossibly mainly of an informal nature) presum-ably already exists in several countries, since itwould appear to have been the source of part ofthe information contained in the report’s surveyof the experience of HLIs’ operations in six juris-dictions. The strongest reservations of the Reportin this area concern enhanced oversight by nation-al authorities of the provision of local currency,which is necessary for the settlement of the greatmajority of speculative positions against a cur-rency. These reservations are due primarily to theWorking Group’s view that formal procedures forthis purpose constitute capital controls.

The unavoidable conclusion regarding theWorking Group’s recommendations on “marketdynamics issues” is that they fall well short ofsymmetry. Although they recognize the concernsrecently expressed about HLIs’ practices in this


area as legitimate, they devote much more atten-tion to the obligations for transparency soughtfrom economic actors in developing and transitioneconomies as part of international financial reform.

Asymmetries in the assessment proceduresassociated with the standards initiatives are alsoexemplified in another report of the FSF (2000d),that of its Working Group on Offshore Centres(OFCs).38 In the context of international financialreform, there is concern that, although OFCs donot seem to have been a major cause of systemicproblems so far, they mightbecome so in the future. Thisis because of the growth inthe assets, liabilities and off-balance-sheet activities of in-stitutions based in OFCs, aswell as growing interbank re-lations. In particular, the fearis that OFCs could prove animportant source of contagion.The terms of reference of theWorking Group included ageneral stock-taking of the usemade of OFCs, and, more par-ticularly, a review of their progress in enforcinginternational prudential and disclosure standards,and in complying with international agreementson the exchange of supervisory information andother information relevant to combating financialfraud and money laundering.

For this purpose, the Working Group organ-ized a survey of OFCs that aimed at assessingcompliance with the international standards ofsupervision established by the BCBS, the IAIS andIOSCO (i.e. with standards for the banking, in-surance and securities business). The survey wasconducted through two questionnaires – one foronshore supervisors in 30 major financial centresand the other for 37 OFCs. The first questionnairewas designed to elicit views on the quality of regu-lation and supervision in those OFCs with which

the onshore supervisors had some degree of fa-miliarity, and on the quality of cooperation theyhad experienced with OFC supervisors. The sec-ond questionnaire was intended to provide infor-mation on how these OFCs interacted with thehome supervisors of suppliers of financial serv-ices operating in or from their jurisdictions (i.e.branches, subsidiaries or affiliates of suppliersincorporated in an onshore jurisdiction). The sur-vey was the basis of a classification of OFCs intothree groups: (i) those generally viewed as co-operative, with a high quality of supervision,

which largely adhered to inter-national standards; (ii) thosegenerally seen as having pro-cedures for supervision andcooperation in place, but whereactual performance fell belowinternational standards andthere was substantial room forimprovement; (iii) those gen-erally seen as having a lowquality of supervision and be-ing non-cooperative with on-shore supervisors (or both),and as making little or no at-

tempt to adhere to international standards. How-ever, several supervisors in OFCs considered thatthe procedures followed in this exercise had pro-vided them with an inadequate opportunity forself-assessment of their regulatory regimes andof the quality of their supervision. Providing OFCswith such an opportunity would have been in bet-ter accord with the spirit of the report’s proposalsconcerning the future programme for assessmentof standards implementation on the part of OFCs.One of the stages specified is self-assessmentassisted by external supervisory expertise (FSF,2000d: 56–60). As a class, OFCs do not arousemuch sympathy within the international commu-nity. However, smooth progress in global initia-tives on standards requires a perception of even-handedness regarding different aspects of theirapplication among all the parties involved.39

Smooth progress in globalinitiatives on standardsrequires a perception ofeven-handedness regardingdifferent aspects of theirapplication among all theparties involved.


Implementation of standards is a process withseveral dimensions and stages. The first step speci-fied in the strategy of the FSF Task Force (FSF,2000a, sect. III) is to identify and achieve inter-national consensus on standards. This is followedby a prioritization exercise so that the process ofimplementation becomes manageable – an exer-cise which has led to the list of key standards intable 4.1. Action plans at the national level thenneed to be drawn up. The primary agents involvedhere are national governments, which consultmultilateral financial institutions and standard-setting bodies as necessary and can receive tech-nical assistance of various kinds. Once implemen-tation of plans is under way, it is subject to as-sessment, partly by the relevant national authori-ties themselves, but also bymultilateral financial institu-tions, standard-setting bodies,and possibly other parties;technical assistance is alsoprovided under this heading.Another integral part of theprocess of implementation isthe dissemination of informa-tion on progress, in particular,to market participants such aslenders and investors.

Implementation is also tobe promoted by official andmarket sanctions and incentives, which have manymutual links.40 One important example on the of-ficial side is the technical assistance alreadymentioned. Others might involve the inclusion ofstandards implementation in policy surveillance(closely linked to assessment exercises), condi-tions attached to official financing (especially that

of multilateral financial institutions), and takinginto account the observance of standards in deci-sions on eligibility for membership of internationalbodies and in regulatory and supervisory decisionsin host countries with respect to a country’s fi-nancial firms abroad. In some of these cases theFSF Task Force is endorsing actions already takenor is advocating further steps in the direction ofsuch actions. But in others the sanctions and in-centives put forward have not yet been the subjectof official decisions and the Task Force itself hasexpressed its awareness of possible drawbacks.

In terms of actions already taken, implemen-tation of financial standards is now included inthe IMF’s policy surveillance under Article IV

(which takes account of theconclusions of the FSAP men-tioned in subsection B.2). Oneof the conditions for a coun-try’s eligibility for financingthrough the IMF’s Contin-gency Credit Line (CCL)41 isa positive assessment duringthe most recent Article IV con-sultations of its progress in ad-hering to internationally ac-cepted standards. There arealso indications of pressure tolink standards implementationto the conditions associated

with other IMF facilities. In particular, steps toimplement and observe specific standards havebeen included in some IMF country programmes.Finally, the granting of market access to a foreignfinancial firm in several countries is already con-ditional on the standard of supervision in its homecountry, and the incentive put forward by the Task

One of the conditions for acountry’s eligibility forfinancing through the IMF’sContingency Credit Line isa positive assessment of itsprogress in adhering tointernationally acceptedstandards.

D. Implementation, sanctions and incentives


Force would presumably reinforce such condi-tions.

Possible official sanctions and incentiveswhich are not currently in place and would notrepresent extension or reinforcement of existingpolicies include various measures. Membership ofbodies such as IOSCO, the Basel-based bodiesconcerned with financial regulation and supervi-sion, or the OECD might be linked to progress instandards implementation. Butthis, as the FSF Task Forcenotes, could actually have theperverse effect of removing asource of peer pressure. Riskweights in setting prudentialcapital requirements for bor-rowing counterparties couldbe differentiated in accordancewith the observance of stand-ards in the jurisdictions wherethey operate. This presupposeseffective assessment of com-pliance, which is not yet inplace and may prove difficultto achieve in some cases. Nonetheless, steps inthis direction are part of some proposals currentlyunder consideration (see box 4.1).42 Supervisioncould be tightened and other regulatory actionstaken regarding the subsidiaries or branches offoreign financial firms whose home supervisorsare in countries where implementation of stand-ards is weak. Such actions might include restrict-ing inter-affiliate transactions and increasingscrutiny of customer identification, for example.As the FSF notes, this would require disclosureto supervisors in host countries of all pertinent in-formation concerning compliance with the stand-ards in question. Another challenge would be toachieve a level of coordination sufficient to avoidregulatory arbitrage among financial centres.

Assessment of the effectiveness and appro-priateness of official and market sanctions andincentives in standards implementation has nowcommenced. The FSAP43 and IMF Article IV sur-veillance will inevitably play a key role in theformer. Among the subjects of surveillance wouldbe progress in standards implementation under theheading of the strength of the financial sector moregenerally. The extensive – and thus resource-con-suming – process of assessment should itself be

subject to continuing evaluation by a body whichneeds to keep a certain distance from the asses-sors. This may prove to be one of the key rolesfor the FSF, though one possibly complicated bymembership in it of important institutions respon-sible for this assessment.

Market sanctions and incentives are to de-pend most importantly on market participants’ useof information on an economy’s observance of

standards in their risk assess-ment. Such information is thenreflected in differentiated cred-it ratings, spreads for borrow-ers, exposure limits and otherlending and investment deci-sions. If these sanctions andincentives are to work, the keyrequirements are: (i) that mar-ket participants be familiarwith international standards;(ii) that they judge them to berelevant to their risk assess-ments; (iii) that they have ac-cess to information on their

observance; and (iv) that this information be de-ployed as an input in their risk assessments (FSF,2000a). Official assistance to the operation of mar-ket sanctions and incentives can take the form ofpromoting disclosure of relevant information aswell as pressures on, and encouragement to, mar-ket participants to take account of standards ob-servance in their decisions.

The effectiveness of market sanctions andincentives depends on their incorporation intomarket practices. Although experience so far hasbeen of a short duration, the FSF has soughtfeedback from market participants to enable pre-liminary conclusions on the effectiveness of suchsanctions and incentives, most importantly in theform of an informal dialogue with participantsfrom 100 financial firms in 11 jurisdictions (FSF,2000e, sect. III).44 This outreach exercise revealedonly limited awareness of the 12 key standards intable 4.1, though the degree of awareness varied,being greatest for the Special Data DisseminationStandard (SDDS) and International AccountingStandards (IAS). Few market participants took ac-count of an economy’s observance of the stand-ards in their lending and investment decisions,although observance of the SDDS was found to

Market participantsconsidered observance ofthe standards lessimportant than theadequacy of a country’slegal and judicialframework, political risk,and economic and financialfundamentals.


Box 4.1

BASEL CAPITAL STANDARDS

The Basel Capital Accord of 1988 was the result of an initiative to develop more internationallyuniform prudential standards for the capital required for banks’ credit risks. The objectives of theAccord were to strengthen the international banking system and to promote convergence of na-tional capital standards, thus removing competitive inequalities among banks resulting from dif-ferences on this front. The key features of this Accord were a common measure of qualifyingcapital, a common framework for the valuation of bank assets in accordance with their associatedcredit risks (including those classified as off-balance-sheet), and a minimum level of capital deter-mined by a ratio of 8 per cent of qualifying capital to aggregate risk-weighted assets. In subsequentyears, a series of amendments and interpretations were issued concerning various parts of theAccord. These extended the definition and purview of qualifying capital, recognized the reduc-tions in risk exposure which could be achieved by bilateral netting meeting certain conditions,interpreted the Accord’s application to multilateral netting schemes, allowed for the effects on riskexposure of collateralization with securities issued by selected OECD public-sector entities, andreduced the risk weights for exposures to regulated securities firms. Simultaneously, the BaselCommittee continued its work on other banking risks, of which the main practical outcome so farhas been the amendment of the 1988 Accord to cover market risk, which was adopted in 1996. The1988 Basel Accord was designed to apply to the internationally active banks of member countriesof the Basel Committee on Banking Supervision, but its impact was rapidly felt more widely; by1999 it formed part of the regime of prudential regulation not only for international, but also forstrictly domestic banks, in more than 100 countries.

From its inception, the 1988 Basel Accord was the subject of criticism directed at such features asits failure to make adequate allowance for the degree of reduction in risk exposure achievablethrough diversification, the possibility that it would lead banks to restrict their lending, and itsarbitrary and undifferentiated calibration of certain credit risks. In the case of country risk, withvery limited exceptions this calibration distinguished only between OECD and non-OECD countries– a feature of the Accord which some developing countries considered unjustifiably discrimina-tory. In the aftermath of the financial crises of the 1990s, the Accord’s contribution to financialstability more generally became a focus of attention. There was special concern here with regard tothe incentives which the Accord’s risk weighting was capable of providing to short-term interbanklending – a significant element of the volatile capital movements during these crises.

The Basel Committee responded by initiating a comprehensive overhaul of the 1988 Accord. Itsfirst proposal for this purpose (A New Capital Adequacy Framework – henceforth New Frame-work), published in June 1999 (BCBS, 1999b), incorporates three main elements or “pillars”:(i) minimum capital rules based on weights that are intended to be more closely connected to creditrisk than those of the 1988 Accord; (ii) supervisory review of capital adequacy in accordance withspecified qualitative principles; and (iii) market discipline based on the provision of reliable andtimely information. In early 2001 (as this TDR was completed), a revised set of proposals wasissued that is designed to take account of comments by the banking industry and supervisors aroundthe world.

The New Framework contains two basic approaches to the numerical standards for capital ad-equacy: the standardized and the internal-ratings-based approaches. A major feature of the stand-ardized approach is the proposal for recourse to the ratings of credit rating agencies in settingweights for credit risk. The New Framework’s proposal regarding the internal-ratings-based ap-proach is still tentative and will require adequate safeguards concerning such matters as the cali-bration of risk and comparability. However, the approach is likely to be an option in the revisedproposals for banks with sufficiently sophisticated systems for handling credit risk.

The New Framework’s proposal for recourse to the ratings of credit rating agencies in settingweights for credit risk has proved highly contentious. Perhaps most importantly, there is a wide-spread view that the track record of the major agencies, especially with respect to identifying theprobability of serious threats to the debt-service capacity of, or defaults by, sovereign borrowers,


is not good enough to justify reliance on them for setting weights for credit risk. Much recentcriticism has focused on the agencies’ performance during the Asian debt crisis. A notable featureof this crisis was the large and swift downgrading of some of the countries affected. Thus a majorconcern here is that, if credit rating agencies’ announcements simply parallel changes in marketsentiment or, still worse, actually follow such changes, they are capable of exacerbating fluctua-tions in the conditions in credit markets and thus financial crises. Recourse to agencies’ ratings forcredit-risk weighting might result in the new capital standards, on occasion, actually exacerbatingthe instability of bank lending.

Statistical studies1 of the effects of rating agencies’ announcements concerning creditworthinesson countries’ borrowing costs show a strong correlation between such announcements and thespreads on dollar-denominated bonds above the yields of United States Treasury bonds of the samematurity. But mere correlation does not settle questions regarding the nature of the role of agenciesduring fluctuations in credit conditions. Only if the announcements of credit agencies concerningchanges in creditworthiness preceded changes in market conditions would it seem reasonable toattribute to them an effective ex-ante capacity to rate credit risk. However, the results of researchon the subject provide weak support for this proposition. Indeed, the findings of this research helpto explain widespread opposition in official circles to major agencies’ ratings for setting banks’minimum capital levels (and not only those in developing and transition economies), an oppositionwhich, it should be noted, is apparently matched by some reluctance among the agencies them-selves to assume such a responsibility.

There is also concern about the expansion in the use of agencies’ ratings for the purposes of eco-nomic policy. The ratings of major rating agencies already have a role in the regulatory frameworkof a number of countries. In the United States, for example, they are used to distinguish investmentgrade from speculative securities for various purposes such as rules governing the securities hold-ings of banks and insurance companies. Nonetheless, the proposals of the New Framework wouldsubstantially extend the influence of major rating agencies and could easily lead to increased offi-cial regulation and oversight.

Other questions have focused on the coverage of major agencies’ ratings in the context of their useof credit-risk weighting. Even in the European Union, according to provisional estimates of theEuropean Commission, coverage of the major credit rating agencies is limited to less than 1,000corporates. In India, to take a developing-country example, in early 1999, out of 9,640 borrowersenjoying fund-based working capital facilities from banks, only 300 had been rated by any of themajor agencies (Reserve Bank of India, 2000: 13–14). Of course, as noted above, the New Frame-work envisages internal-ratings-based approaches to the setting of banks’ credit-risk weights as analternative to recourse to the ratings of credit rating agencies for sufficiently sophisticated banks.But other banks might still need to make extensive use of the New Framework’s proposed riskweightings for unrated exposures. In view of the unsatisfactory character of this alternative, therehave been calls for greater emphasis in the Basel Committee’s revised proposals on recourse to theratings of domestic (as opposed to major international) rating agencies – a proposal not in factexcluded from the New Framework so long as the agencies in question meet certain minimumcriteria.

As for the promotion of greater stability in international bank lending through incentives to tightercontrol over short-term interbank exposures, the proposals of the New Framework are widely re-garded as still inadequate. This is because, under one of the options for credit-risk weighting,exposures with an original maturity of up to six months to banks within a broad range of creditratings would be attributed a weighting more favourable than those with longer maturities (subjectto a floor). In the light of recent experience, a more restrictive approach to short-term interbankclaims may indeed be required.

1 These studies are summarized in Cornford (2000b, sect. VI.A).

Box 4.1 (concluded)


influence economies’ credit ratings. Generally,market participants considered observance of thestandards less important than the adequacy of acountry’s legal and judicial framework, politicalrisk (often rated as more important than regula-tory or supervisory risk), and economic and fi-nancial fundamentals. Rating agencies, which tendto be better acquainted with both the standardsand the assessment exercises undertaken so far,nonetheless considered that their direct access tonational authorities provided them with a betterunderstanding of the quality of regulation andsupervision, of policy and data transparency, andof market infrastructure.45

It is too early to make more than a highlypreliminary evaluation of standards implementa-tion and of the effectiveness of incentives. Thelarge potential costs of the administrative burdenassociated with implementation and assessmentare widely acknowledged. But the effectivenessof measures proposed to alleviate this burden hasyet to be proved. In the case of the official sanc-tions and incentives mentioned above, many arestill only being considered and not all will neces-sarily be adopted. The inclusion of standards im-plementation in IMF conditionality is still at anearly stage, and its extension in this area remainshighly contentious. The impact of market sanc-

tions and incentives on standards is likely to taketime. This is indeed reflected in the feedback frommarket participants concerning factors that over-ride standards observance in their decisions. Forexample, market participants’ reference to theoverriding significance of the quality of the legaland judicial framework – one of the targets of thestandards – should be viewed in the light of thelength of time required for the standards to havean impact. Similar considerations apply in vary-ing degrees to political risk (where market par-ticipants cited the threat of nationalization andpolicy reversals) and economic and financialfundamentals. Regarding incorporation of stand-ards observance as a factor in the decision-making processes of market participants, there isa chicken-and-egg problem, at least in the mediumterm. By taking account of standards observancein their lending and investment decisions, marketparticipants are supposed to make an importantcontribution to such observance. However, dur-ing the early stage of standards observance, itsimpact on the determinants of creditworthinessand the investment climate is at most still super-ficial. This means that market participants willcontinue to rate this subject as being of limitedimportance, and it will, therefore, have a corre-spondingly low weight in their lending and invest-ment decisions.


As already mentioned, the improvementsdescribed in previous sections will entail extensivechanges for many countries, and their implemen-tation could be lengthy. This is particularly trueof the required reforms in the legal and regula-tory framework and of their incorporation into thenorms of business practice, which is a prerequi-site for receiving the full benefit of these reforms.The gradual and difficult nature of this processfor developing and transition economies shouldnot be taken as a reflection on their legislative andadministrative competence or their political will.For example, the process of deregulating finan-cial sectors in OECD countries or of putting inplace a single-market regime in the EuropeanUnion for the banking and securities business –both processes involving obstacles and constraintssimilar to those confronting the global regimes offinancial standards – took decades.46

The limits on the efficacy of enhanced stand-ards and associated legal and regulatory reformsreflect various factors. One of these is the rooted-ness of standards in past experience, which makesthem less than perfect for dealing with the conse-quences of innovation. Moreover, many of thestandards covered by recent initiatives are directedat the behaviour of economic agents and the func-tioning of firms and markets. Stronger foundationsat this level can reduce – but not eliminate – thelikelihood and magnitude of systemic instability.Malpractice and fraud may become easier to de-tect as standards are enhanced, but they will notdisappear. The collapse of Barings in early 1995is an example of the broader destabilizing poten-tial of events originating in malpractice within asingle firm. More importantly, systemic crises in

the financial sector are often closely linked tomacroeconomic dynamics and to developments atthe international level – or regional level within acountry – which transcend particular nationalfinancial sectors. A Utopian vision of standardsmight include standards for macroeconomic poli-cy designed to put an end to phenomena such asboom-bust cycles, which historically have fre-quently proved to be the financial sector’s nemesis.But, as already noted in subsection B.1, the codesof good practices regarding various aspects ofmacroeconomic policy in table 4.1 concern trans-parency and procedural issues, and not the con-tents of such policy itself.

The crucial field of banking supervision il-lustrates the limitations of standards. A naturalstarting-point here is the licensing of banks. Insome countries the relevant criteria were longdesigned primarily to ensure adequate levels ofcompetence and integrity among those owning andcontrolling a bank. But licensing is often also usedto serve less limited objectives, such as the avoid-ance of “overbanking”, limitation of financial con-glomeration, and (in the case of foreign entities)restricting foreign ownership of the banking sec-tor, or ensuring that the parent institution is ad-equately supervised in its home country. Theobjectives of licensing may have (usually proxi-mate) relations to banking stability, but they can-not prevent serious banking instability or bankingcrises. Another major subject of banking supervi-sion is implementation of prudential regulation,much of which is concerned with ensuring ad-equate management and internal controls, butwhich also includes prudential capital require-ments.47 A key purpose of capital here is to pro-

E. Standards, financial regimes and financial stability


vide a stable resource to absorb any losses incurredby an institution, and thus protect the interests ofits depositors. Capital requirements for credit andmarket risks are also clearly intended to contri-bute to financial risk management of assets andliabilities, as well as to appropriate pricing of thedifferent products and services which a bankoffers. Prudential capital, by strengthening finan-cial firms, reduces the likelihood of major finan-cial instability originating in the failure of a singlefirm. It also increases such firms’ defences againstinstability originating elsewhere. However, itscontribution to restraining financial instabilitystops here. Other prudential guidelines or rulesare directed at subjects such as exposure to foreign-exchange risks, risks due to large exposures tosingle counterparties or groups of related counter-parties, adequate liquidity, loan-loss provisions, consolidatedfinancial reporting and coun-try exposures. These guide-lines and rules serve the sameobjectives as prudential capi-tal, and their efficacy is sub-ject to the same limitations.

These limitations are ex-plicable, at least in part, interms of the considerationsraised above concerning standards more generally.Financial regulation is constantly struggling tokeep up with financial innovation, and in thisstruggle it is not always successful. There is thus acontinuing danger that new practices or transac-tions, not yet adequately covered by the regulatoryframework, may prove a source of financial in-stability. Closely related in many ways to financialinnovation, are difficulties – which have becomemore important in recent years – regarding thetransparency required for regulation and supervi-sion. The balance sheets of many financial firmshave an increasingly chameleon-like quality whichreduces the value of their financial returns toregulators. Consequently, the tensions betweenfinancial innovation and effective regulation inmodern financial markets are unlikely to disap-pear. In principle, one can envisage a tighteningof regulation sufficiently drastic as to come closeto eliminating the dangers due to innovation. How-ever, the tightening would be too stifling to bepolitically acceptable in any country that valuesdynamism in its financial sector.

Probably the most important determinant ofthe intrinsic limitations of regulation and super-vision is the unavoidable dependence of financialstability on macroeconomic stability more gener-ally.48 Most assets of banks are susceptible tochanges in their quality resulting from broaderchanges in economic conditions. So long as cy-cles of financial boom and bust are features of theeconomic system, so also will be unforeseeabledeteriorations in the status of many bank assets.49

Where banking crises are combined with currencycrises, and cross-border as well as domestic fi-nancing contributes to the boom (as in many re-cent instances involving developing economies),the process is fuelled by forces similar to thosethat characterize purely domestic credit cycles.These include herd behaviour of lenders and in-

vestors, driven partly by thevery conditions their lendingand investment have helped tocreate, but also by competitionwithin the financial sector.Other forces include the all tooready acceptance, for exam-ple, of benchmarks resultingfrom collective behaviour,poor credit evaluation (oftenexacerbated in the case ofcross-border financing by less

familiarity with the borrowers and their econo-mies), and the pressures on loan officers resultingfrom target returns on capital. An important dis-tinctive feature of boom-bust cycles with a cross-border dimension is another macroeconomic fac-tor – the exchange rate. Capital inflows generallycome in the first place in response to exchange-rate adjusted returns, and thus on assumptionsabout the stability of the exchange rate. The out-flows are in most cases associated with movementsin contradiction with these assumptions, in theform of a large depreciation of the currency. Thisoften has devastating effects on the net indebted-ness and income of many domestic economicactors.

In thinking about the interaction betweenbroader types of financial instability and difficultyin controlling financial risks, as experienced inthe internal controls of banks as well as in theirsupervision, the concept of “latent concentrationrisk” (used in some recent literature on credit riskto denote problems due to unpredictable correla-

Financial regulation isconstantly struggling tokeep up with financialinnovation, and in thisstruggle it is not alwayssuccessful.


tions between defaults) can be an illuminating one.This concept also serves to pinpoint relations be-tween uncertainty, on the one hand, and the limi-tations of banking supervision, on the other.50

Concentration risk is traditionally handled in thecontext of banking regulation and supervisionthrough limits on the size of exposures to particu-lar borrowers. For this purpose, “borrower” istypically defined to include groups of counter-parties characterized by links due to commonownership, common directors, cross-guarantees,or forms of short-term commercial interdepend-ency. But boom-bust cycles bring into focus risks

due to latent concentration, as they lead to dete-rioration in the economic positions of counter-parties apparently unconnected in other, morenormal, times. Indeed, a common feature of theboom-bust cycle would appear to be exacerbationof the risk of latent concentration as lenders moveinto an area or sector en masse prior to attemptsto exit similarly. To some extent, the risks oflatent concentration can be handled through pru-dential measures, such as banks’ general loan-lossreserves and capital requirements for credit risk,but there are limits to the efficiency of such meas-ures.

Notes

1 The Financial Stability Forum was established bythe finance ministers and central bank governors ofthe Group of Seven in February 1999 to promoteinternational financial stability through improvedexchange of information and cooperation with res-pect to financial supervision and surveillance. Itsmembership consists of the national authorities re-sponsible for financial stability in selected OECDcountries, Hong Kong (China) and Singapore, andmajor international financial institutions, interna-tional supervisory and regulatory bodies and cen-tral-bank expert groupings.

2 An example of such dangers was furnished by thelarge-scale withdrawal of funds from and subsequentbankruptcy of two Deak and Co. subsidiaries (DeakPerera Wall Street and Deak Perera InternationalBanking Corporation) in response to informationin a 1984 report of the United States PresidentialCommission on Organized Crime concerning DeakPerera’s involvement in money laundering.

3 This part of the rationale for standards is particu-larly emphasized in Drage, Mann and Michael(1998:77–78).

4 The distinction between banking regulation and su-pervision in the literature is not particularly clearcut.But regulation can be taken roughly to refer to rules,

both those set out in banking legislation and thosereferring to the instruments and procedures of thecompetent authorities. Supervision refers to imple-mentation including licensing, ongoing off-site andon-site supervision of institutions, enforcement andsanctioning, crisis management, the operation ofdeposit insurance, and procedures for handling bankinsolvencies. These distinctions follow closely thosein Lastra (1996: 108).

5 The BCBS comprises representatives of the centralbanks and supervisory authorities of Belgium,Canada, France, Germany, Italy, Japan, Luxem-bourg, Netherlands, Sweden, Switzerland, UnitedKingdom and United States. For an account of theacceptance of the BCBS’s standards beyond itsmembership, primarily in relation to prudentialstandards for bank capital, see Cornford (2000b,sect. III).

6 For a discussion of these assessments of compli-ance, see IMF (2000d).

7 The members of the CPLG are from Argentina, Aus-tralia, Brazil, Chile, China, Czech Republic, Com-mission Bancaire de l’Union Monétaire OuestAfricain, France, Germany, Hong Kong (China),India, Italy, Japan, Mexico, Netherlands, Republicof Korea, Russian Federation, Saudi Arabia, Singa-


pore, South Africa, United Kingdom and UnitedStates. In addition, the CPLG has representativesfrom the European Commission, the Financial Sta-bility Institute, the IMF and the World Bank.

8 This is recognized in the IMF paper cited above con-cerning the experience of the early assessment ex-ercises as follows: “Due to lack of manpower andtime, the assessments are not always as in-depth aswarranted to identify all the underlying weaknesses.It is also difficult to obtain a thorough understand-ing of the adequacy of supervisory staff numbersand skills, as well as the skills of commercial bank-ers. A genuine assessment of bank supervision re-quires in-depth on-site review – including interviewswith supervisors and bankers – resulting in well-researched judgements on institutional capacity andsupervisors’ concrete achievements” (IMF, 2000d,para. 57).

9 In 1996, for example, before the outbreak of theEast Asian financial crisis, the ratio of capital torisk-weighted assets in the Republic of Korea, ac-cording to official estimates, was above 9 per cent.However, if accounting rules closer to internationalnorms had been used, non-performing loans for thesector as a whole would have exceeded its combinedcapital funds (Delhaise, 1998: 115). By the mid-1990s, in a number of countries affected by the cri-sis, the capital standards of the 1988 Basel Accordwere part of the legal regime for banks (TDR 1998,Part One, chap. III, box 3). But in the absence ofproper rules for the valuation of banks’ assets, thisstandard had little meaning for many of the institu-tions to which it was supposed to apply.

10 For a survey of banks’ accounting practices andother financial reporting under regulatory regimesin 23 mainly industrial countries that highlights theprevalence and extent of shortfalls from interna-tional best practice in the first half of the 1990s, seeCornford (1999, sect. III).

11 This framework for analysing policies aimed at thestability of the financial sector is frequently de-ployed by William White of the BIS (White,1996: 23).

12 Traditionally, such transactions have depended onnational payment systems for the transfer of fundsbetween correspondent banks of the countries whosecurrencies are involved. For example, in the case ofa cross-border payments order transmitted betweenbanks through SWIFT (Society for WorldwideInterbank Financial Telecommunication – a privatecompany which transmits financial messages for thebenefit of its shareholding member banks and ofother approved categories of financial institutionsin 88 countries), the banks must arrange the clear-ing and settlement themselves, either relying onmutual bilateral correspondent relationships or for-warding the orders to domestic systems for interbank

fund transfers. Many major banks have introduced“straight-through processing”, in which there is anautomated linkage between their SWIFT connec-tion and their computers linked to the domestic pay-ments system (BIS, 1997: 482–485). More recentlythere has been growth in the direct settlement offoreign exchange transactions between parties indifferent jurisdictions through systems processingpayments in more than one currency.

13 IOSCO is a grouping of securities regulators (bothgovernmental and self-regulatory bodies) from morethan 90 countries. Created in 1984, it is a private,non-profit organization whose main objectives arecooperation for better market regulation, informa-tion exchange, standard setting, and mutual assist-ance in the interest of protecting market integrity.

14 For a commentary on the Core Principles and dis-cussion of the initiative’s background, see Sawyerand Trundle (2000). (John Trundle of the Bank ofEngland was chairman of the Task Force which drewup the Core Principles.)

15 More specifically, the initiative was a response tothe conclusion in the report of an ad hoc workingparty on financial stability in emerging marketeconomies, set up after the 1996 summit of theGroup of Seven, concerning the essential role ofsound payment systems in the smooth operation ofmarket economies, as well as to growing concernregarding the subject among emerging marketeconomies themselves. See mimeograph documentof the Working Party on Financial Stability inEmerging Market Economies, Financial stability inemerging market economies: A strategy for the for-mulation, adoption and implementation of soundprinciples and practices to strengthen financial sys-tems (April 1997, chap. II).

16 In a multilateral netting arrangement a participantnets obligations vis-à-vis other participants as agroup throughout a specified period (typically aday), and then settles the debit or credit balanceoutstanding at the end of this period through thearrangement’s common agent.

17 Part 2 was a response to widespread comments elic-ited by Part 1 that more detail on interpretation andimplementation was needed.

18 This Programme is aimed at assessing the vul-nerabilities of countries’ financial sectors and iden-tifying priorities for action, partly in the light of in-ternationally agreed standards for these sectors.

19 The IASC was created in 1973 by major professionalaccounting bodies and now includes more than130 such bodies from more than 100 countries. Theentities concerned with international accountingstandards include not only professional accountingbodies, international accounting firms, transnationalcorporations and other international lenders and in-vestors, but also other bodies such as international


trade unions concerned with cross-border businessactivities.

20 A 1997 study of the United States Financial Ac-counting Standards Board (FASB) identified 255variations between United States and internationalstandards, many of which were judged as signifi-cant. See Scott and Wellons (2000: 67). For a moreextended discussion of the IASC-US ComparisonProject, which was the source of this finding, seeGrossfeld (2000).

21 Specific topics identified as the most difficult forthe achievement of reconciliation and understand-ing among countries in a survey of institutional in-vestors, firms, underwriters and regulators in the firsthalf of the 1990s (quoted in Iqbal, Melcher andElmallah, 1997: 34) were the following: account-ing for goodwill, deferred taxes, inventory valua-tion, depreciation methods, discretionary reserves,fixed-asset valuation, pensions, foreign currencytransactions, leases, financial statement consolida-tion and financial disclosure requirements.

22 IFAC was established in 1977 to promulgate inter-national standards in auditing and closely relatedsubjects. IFAC and IASC have an agreement of “mu-tual commitments” for close cooperation and mu-tual consultations, and membership in one automati-cally entails membership in the other.

23 This point is forcefully made with the support of awealth of case studies from the business history ofthe United States in Kennedy (2000, part 1).

24 The arrangements proposed below, in chap. VI,sect. B, for orderly workouts in the case of cross-border debt depend, for their functioning, on ad-equate national insolvency regimes.

25 The account which follows relies heavily on theGroup of Thirty (2000, chap. 2, sect. 1).

26 This point was made recently in an OECD publica-tion: “The incidence of banking crises, and the coststhese have imposed on countries, is quite large andthe systemic consequences of the failure of a largeinstitution are of a different order of magnitude fromthose associated with the failure of smaller institu-tions. In particular, the costs of bailing out a verybig institution might be large relative to the resourcesof the country in which the institution resides. … itis not clear that an increase in size and perhaps geo-graphic scope of an institution makes the risk of itsfailure any greater than before. Accidents do hap-pen, however, and it is likely that the systemic con-sequences of bank failures grow as institutions be-come larger and larger. The situation is also morecomplex in the case of internationally operatingbanks” (OECD, 2000c: 138–139).

27 See Group of Thirty (2000, especially chaps. 4–6). Thepolicy issues are surveyed in Group of Thirty (1998).

28 For more detailed guidelines for the Principles’ ap-plication, see International Association of Insurance

Supervisors (IAIS, 2000b). The IAIS is an associa-tion of insurance supervisors established in 1994and now includes supervisors from more than100 countries.

29 The main forum dealing explicitly with these issuesis the Joint Forum on Financial Conglomerates,which was founded in 1996 and brings together de-veloped-country representatives from the BCBS,IOSCO and IAIS. The Joint Forum has reviewedvarious means of facilitating the exchange of infor-mation among supervisors within their own sectorsand among supervisors in different sectors, and hasinvestigated legal and other barriers that impede theexchange of information among supervisors withintheir own sectors and between supervisors in differentsectors. It has also examined other ways to enhancesupervisory coordination, and is working on devel-oping principles for the more effective supervisionof regulated firms within financial conglomerates.

30 See, for example, the coverage of recent events ofmoney laundering in London in the Financial Times,20 October 2000, and of a report of the subcommit-tee of the United States Senate concerning use ofcorrespondent services provided by the country’sbanks for the purpose of money laundering in theInternational Herald Tribune, 6 February 2001. ANew York Times editorial reproduced in the lattercommented as follows: “Banks are undoubtedlywary of legal restrictions that raise costs and dis-courage depositors, particularly in their lucrativeprivate banking divisions. But America cannot con-demn corruption abroad while allowing its ownbanks to make fortunes off it.”

31 Various other regional or international bodies, ei-ther exclusively or as part of their work, also par-ticipate in combating money laundering. These in-clude the Asia/Pacific Group on Money Launder-ing (APG), the Caribbean Financial Action TaskForce (CFATF), the PC-R-EV Committee of theCouncil of Europe, and the Offshore Group of Bank-ing Supervisors.

32 Attention is drawn to such connections between dif-ferent international initiatives concerning offshorefinancial centres by José Roldan, President of theFATF during the period July 2000–2001, in an in-terview (Roldan, 2000: 21–22).

33 For a more detailed commentary on this report, seeCornford (2000a).

34 This FSF report focuses mainly on large, substan-tially unregulated institutions characterized by lowtransparency, primarily hedge funds. But, as the re-port notes, a clear distinction cannot always bedrawn between the practices of these institutions andothers subjected to greater regulation.

35 The six economies were Australia, Hong Kong(China), Malaysia, New Zealand, Singapore andSouth Africa.


36 One instance of such activity, which attracted muchattention in 1998, was the “double play” in whichsome financial institutions are believed to have en-gaged in Hong Kong (China). This operation is de-scribed as follows in the Working Group’s report(FSF, 2000c: 117): “Some market participants sug-gested that there were attempts to carry out a ‘dou-ble play’ involving the equity and currency mar-kets, whereby short positions would be first estab-lished in the equity (or equity futures) market, andsales of Hong Kong dollars would then be used todrive up interest rates and thereby depress equityprices. Some other market participants questionedwhether such a strategy was pursued. Any doubleplay would have been facilitated at that time by in-stitutional factors in the linked exchange rate ar-rangement which made short-term interest rates verysensitive to changes in the monetary base, and alsoby reduced market liquidity as a result of the Asiancrisis. Among those taking short positions in the eq-uity market were four large hedge funds, whose fu-tures and options positions were equivalent to around40 percent of all outstanding equity futures contractsas of early August, prior to the HKMA [Hong KongMonetary Authority] intervention (there were no lim-its or reporting requirements on large equity futurespositions at this time). Position data suggest a correla-tion, albeit far from perfect, in the timing of the estab-lishment of the short positions.” See also Yam (1998).

37 A working group of the Committee on the GlobalFinancial System on Transparence Regarding Ag-gregate Positions (the Patat Group), whose mandatewas to look at what aggregate data on financialmarkets could be collected to enhance their efficientoperation, was abolished because of its finding that“it would not be possible to obtain adequately com-prehensive and timely information on a voluntarybasis, and legislative solutions were deemed imprac-tical” (see White, 2000: 22).

38 As the report notes (FSF, 2000d: 9), OFCs are noteasily defined, but can be characterized as jurisdic-tions that attract a high level of non-resident activ-ity. Traditionally, the term has implied some or allof the following: low or no taxes on business orinvestment income; no withholding taxes; light andflexible incorporation and licensing regimes; lightand flexible supervisory regimes; flexible use oftrusts and other special corporate vehicles; no re-quirement for financial institutions and/or corpo-rate structures to have a physical presence; an inap-propriately high level of client confidentiality basedon impenetrable secrecy laws; and unavailability ofsimilar incentives to residents. Since OFCs gener-ally target non-residents, their business substantiallyexceeds domestic business. The funds on the booksof most OFC are invested in the major internationalmoney-centre markets.

39 The point was eloquently expressed in a recent edi-torial in the periodical, The Financial Regulator, asfollows: “ The interconnection of the world finan-cial system has created … problematic externali-ties, with … small countries now able to do a lot ofdamage. With world government some way off,these externalities are likely to prove tricky to man-age. For the foreseeable future there is no bettersolution than international cooperation. When bigcountries push little countries around, even for thebest of reasons, they give this crucial cooperation abad name. The challenge for those interested in glo-bal financial stability is to find some way of negoti-ating better regulation while avoiding … the heavy-handedness characterizing the current drive againstoffshore centres.” See “Justice for offshore centres”,The Financial Regulator, September 2000.

40 The term “incentive” is used by the FSF in this con-text to cover measures which include sanctions aswell as incentives.

41 For a description of the CCL, see chap. VI, box 6.3.42 BCBS has proposed in its A New Capital Adequacy

Framework (see box 4.1) the following incentiveswith regard to observance of standards: (i) to be eli-gible for claims on it to receive a risk weightingbelow 100 per cent, a country would have to sub-scribe to the SDDS; (ii) claims on a bank will onlyreceive a risk weighting of less than 100 per cent ifthe banking supervisor in that country has imple-mented – or has endorsed and is in the process ofimplementing – the BCBS’ Core Principles for Ef-fective Banking Supervision; and (iii) claims on asecurities firm will only receive a risk weighting ofless than 100 per cent if that firm’s supervisor hasendorsed – and is in the process of implementing –IOSCO’s Objectives and Principles of SecuritiesRegulation (1998).

43 See note 18 (sect. B.3) above.44 The jurisdictions covered by the outreach exercise

were Argentina, Australia, Canada, France, Ger-many, Hong Kong (China), Italy, Japan, Sweden,United Kingdom and United States.

45 Nevertheless, as discussed in box 4.1 (on proposalsfor reform of the Basel Capital Accord), how effec-tively the agencies have used this understanding isstill open to question.

46 Deregulation of interest rates in major OECD coun-tries, for example, has taken from seven to morethan 20 years in all but a small minority of cases.The establishment of a single market for financialservices in the EU took more than 30 years (seeCornford and Brandon, 1999: 11–13).

47 Capital requirements are attributed a central role incountries’ regimes of prudential regulation and su-pervision. They have also been the subject of majorinternational initiatives, of which the most impor-tant is the Basel Capital Accord that is currently


undergoing a major revision . See box 4.1 on BaselCapital Standards.

48 This dependence, of course, provides the link be-tween sectoral policies aimed at financial stabilityand macroeconomic policies, including those di-rected at the balance of payments (amongst which,especially for developing and transition economies,should be counted controls on capital transactions).

49 The argument here follows closely that of Akyüzand Cornford (1999: 30–31). See also TDR 1998(Part One, chap. IV, sect. C.3).

50 See, for example, Caouette, Altman and Narayanan(1998: 91, 240). The limitations of credit risk mod-els in handling correlations among defaults are re-viewed in BCBS (1999c, Part II, sect. 6, and Part III,sect. 3).

109Exchange Rate Regimes and the Scope for Regional Cooperation

Exchange rate regimes in developing coun-tries and transition economies have attractedincreased attention in the recent debate on the re-form of the international financial architecture inview of their contribution to external vulnerabil-ity, and currency and financial crises. In countriesthat are closely integrated into international finan-cial markets, adjustable peg regimes (the so-calledsoft pegs) are increasingly seen as the major causeof boom-bust cycles in financial flows. Conse-quently, the mainstream advice is that they eitheradopt a regime of freely floating exchange ratesor that they make a credible commitment to de-fend a fixed exchange rate by locking into areserve currency through currency boards or byadopting a reserve currency as their national cur-rency (dollarization); in other words, they areadvised to go for one of the so-called “corner”solutions as opposed to the intermediate regimesof adjustable pegs.1 According to some estimates,almost two thirds of emerging-market economieswere using intermediate exchange rate regimesin 1991, but by 1999 this proportion had fallen to42 per cent, and the proportion using hard pegsor some variant of floating had risen to 58 percent (Fischer, 2001, fig. 2). However, while many

countries afflicted by financial crisis in the pastdecade have subsequently adopted floating rates,the increased volatility associated with such re-gimes has become a source of concern. As a result,there now appears to be a greater interest amongdeveloping countries and transition economies inhard pegs. And increasingly, in a closely integratedglobal financial system, the existence of manyindependent currencies is being called into ques-tion (Hausmann, 1999).

For emerging-market economies, adjustablepeg regimes are problematic under free capitalmobility as they lead to boom-bust cycles andovershooting of exchange rates. However, neitherfree floating nor hard pegs constitute viable alter-natives. Currency misalignments and gyrationsassociated with floating regimes can have seriousconsequences for developing countries with smalland open economies and a relatively large stockof external debt denominated in reserve curren-cies. On the other hand, for most developingcountries and transition economies, a policy oflocking into a reserve currency and surrenderingmonetary policy autonomy can entail considerablecosts in terms of growth, employment and inter-

Chapter V

EXCHANGE RATE REGIMES AND THE SCOPEFOR REGIONAL COOPERATION

A. Introduction


national competitiveness – costs that far exceedthe benefits such a regime may yield in terms ofprice and exchange rate stability. These conclu-sions are shared in a paper on exchange rateregimes for emerging-market economies jointlyprepared by staff of the French and Japanese Min-istries of Finance, on the occasion of the meetingof European and Asian finance ministers in Kobe,Japan, in January 2001:

There is no guarantee that currency boardarrangements escape from the same draw-backs as pegged regimes. … Free-floatingstrategies have their own costs of possibleexcessive volatility and free riding risks.(Ministry of Finance, Japan, 2001: 3–4)

A consequence of the mainstream advice isthat developing countries with similar foreigntrade structures and market orientation couldend up at opposite ends of thespectrum of exchange rates –some with floating and oth-ers with fixed exchange ratesagainst the dollar – even ifthere is a considerable amountof trade amongst them. Con-sequently, not only would theircurrencies be floating againsteach other, but also their bi-lateral exchange rates wouldbe greatly influenced by theoverall movement of the dol-lar against other currencies.Given the misalignments andfluctuations that character-ize the currency markets, thiswould imply erratic, unex-pected shifts in the competitive position of devel-oping countries vis-à-vis each other. When thereis considerable bilateral trade, as between Braziland Argentina, such shifts can have an importantimpact on their economies, leading to tensions intrade relations. Briefly stated, unilateral corner so-lutions may result in inconsistent outcomes for thedeveloping countries taken together.

The key question is whether there exists aviable and appropriate exchange rate regime fordeveloping and transition economies that areclosely integrated into global financial marketswhen major reserve currencies are subject to fre-quent gyrations and misalignments, and when the

size and speed of international capital movementscan very quickly overwhelm the authorities in suchcountries and narrow their policy options. Canthese countries be expected to solve their exchangerate problems unilaterally when the magnitude, di-rection and terms and conditions of capital flowsare greatly influenced by policies in major reservecurrency countries, and when international cur-rency and financial markets are dominated byspeculative and herd behaviour? Certainly, con-trols over capital flows can facilitate the prudentmanagement of their exchange rates. Indeed, a fewcountries, such as China, have so far been able topursue adjustable peg regimes without runninginto serious problems. However, several emerg-ing markets have already made a political choicein favour of close integration into the globalfinancial system and are unwilling to control capi-tal flows. Furthermore, it may be very difficult for

any single country to resist thestrong trend towards liberali-zation of capital movements,particularly if it has close linkswith international marketsthrough FDI and trade flows.

While all this implies thatthe solution should, in princi-ple, be sought at the globallevel, the prospects for this arenot very promising, given thestance of the major powers onthe question of exchange rates.Since global arrangements fora stable system of exchangerates are not foreseeable in thenear future, the question arises

as to whether viable solutions can be found at theregional level. In this respect, the post-BrettonWoods experience of Europe in establishingmechanisms to achieve a stable pattern of intra-regional exchange rates, and eventually move toa currency union, may hold useful lessons for de-veloping regions, particularly East Asia and SouthAmerica. However, while regional currency ar-rangements and monetary cooperation amongdeveloping countries could bring some benefits,they do not resolve the problem of what currencyregime to adopt and how to achieve exchange ratestability vis-à-vis G-3 currencies. Even if theycould achieve greater integration, developingcountries could not neglect their exchange rates

The key question is whetherthere exists a viable andappropriate exchange rateregime for developingeconomies when majorreserve currencies aresubject to frequent gyrationsand misalignments, andwhen international capitalmovements are extremelyunstable.


vis-à-vis such currencies. It thus appears that re-gional arrangements among developing countriesmay need to involve major reserve-currency coun-

tries or rely on a common regime of capital con-trols in order to achieve stability and avoid costlycrises.

B. Exchange rate regimes

1. Soft pegs

It has long been established that an economywhich is fully committed to free movement ofcapital (or which does not succeed in effectivelycontrolling capital movements) cannot both fix itsexchange rate (at a given value or within a nar-row band) and pursue an independent monetarypolicy. Any attempt to do so will eventually runinto inconsistencies that will force the country toabandon one of the objectives. One option wouldbe to adhere to fixed exchange rates throughcurrency boards or outright dollarization at theexpense of autonomy in monetary policy. Anotherwould be to move to floating exchange rates,thereby freeing monetary policy from defendinga particular exchange rate (or a narrow band).The breakdown of the Bretton Woods system ofadjustable pegs, the 1992–1993 crisis in the Ex-change Rate Mechanism (ERM) of the EuropeanMonetary System (EMS) and the recent episodesof crisis in emerging markets are all seen as theoutcome of the inconsistency between capitalaccount openness, exchange rate targeting andindependent monetary policy.

The Bretton Woods system of adjustablepegs operated with widespread controls overinternational capital movements. However, incon-sistencies between the pattern of exchange ratesand the domestic policy stances of major coun-tries created serious payments imbalances and

incentives for capital to move across borders, cir-cumventing the controls. This eventually led tothe breakdown of the system and the adoption offloating rates. Even though the adjustable pegs inthe EMS constituted a step towards monetary un-ion (hard pegs) and were supported by extensiveintraregional monetary cooperation, inconsisten-cies between macroeconomic fundamentals andexchange rates led to a crisis and breakdown ofthe ERM in 1992–1993.The adoption of soft pegsis also considered to be one of the root causes ofrecent financial crises in emerging-market econo-mies such as Mexico, Thailand, Indonesia, theRepublic of Korea, the Russian Federation andBrazil. The subsequent move by these countriesto floating rates is often interpreted as the recog-nition that soft pegs are not viable for countriesclosely integrated into the global financial mar-kets.

The role of soft pegs in contributing to ex-ternal fragility and the outbreak of financial crisesin emerging markets is well established.2 Mostemerging-market economies offer higher nominalinterest rates than the industrialized world, in largepart because of higher inflation rates. These createshort-term arbitrage opportunities for internationalinvestors and lenders, as well as incentives fordomestic firms to reduce their costs of finance byborrowing abroad. On the other hand, by provid-ing implicit guarantees to international debtors andcreditors, currency pegs can encourage imprudentlending and borrowing. The risk of depreciation


is discounted owing to the stability of the nomi-nal exchange rate and the confidence createdby rapid liberalization and opening up of theeconomy. The credibility of the peg as well asarbitrage opportunities are enhanced when thecountry pursues a tight monetary policy in orderto bring down inflation or prevent overheating ofthe economy.

However, a nominal peg with a higher infla-tion rate also causes an appreciation of the cur-rency in real terms and a widening of the current-account deficit. If external deficits and liabilitiesare allowed to mount, the currency risk will riserapidly. Since there is no firm commitment to de-fend the peg, the worsening fundamentals even-tually give rise to expectations of a devaluationand a rapid exit of capital. Not only does this causeliquidity shortages; it also forces the monetary au-thorities to tighten monetarypolicy and restrict liquidityeven further. Sooner or later,the exchange rate peg is aban-doned, leading to a free fallwhich, together with the hikein interest rates, causes enor-mous dislocation in the econo-my.

Despite the risk of costlycurrency swings and crises,many countries with relativelyhigh rates of inflation have often favoured stabi-lizing the internal value of their currencies bystabilizing their external value through anchoringto a reserve currency with a good record of sta-bility. This is true not only for the small and openEuropean economies such as Austria, the Nether-lands and Belgium, but even for a large economysuch as Italy, which faced several speculativeattacks against its currency and experienced dis-ruptions throughout the process of convergencetowards the inflation rates of its larger tradingpartners in the EU. Many emerging-market econo-mies, notably in Latin America, have also usedsoft pegs for disinflation. Although it proved dif-ficult to achieve an orderly exit from such pegs inorder to realign their currencies, it is notable thatthese countries managed to avoid the return ofrapid inflation in the aftermath of crises, despitesharp declines in their currencies. For instance,after the introduction of an exchange-based

stabilization plan (Plano Real) in 1994, Brazil suc-ceeded in bringing down its inflation rate from afour-digit level to a single-digit level by 1998. De-spite various adjustments in the value of the realand a relatively rapid decline in inflation, theBrazilian currency had appreciated by some 20 percent at the end of the disinflation process. How-ever, it was not possible to engineer an orderlyrealignment of the exchange rate, which cameunder severe pressure at the end of 1998, partlydue to spillovers from the Russian crisis. Butafter an initial hike, inflation stabilized at low lev-els despite a sharp drop in the value of the realagainst the dollar (see TDR 1999, Part One,chap. III, sect. B).

Appreciation is generally unavoidable in ex-change-based stabilization programmes because ofstickiness of domestic prices. More fundamental-

ly, it is part of the rationale ofsuccessful disinflation, sincegreater exposure to interna-tional trade – resulting in lowerimport prices and increasedcompetition in export markets– helps to discipline domesticproducers and acts as a breakon income claims. However,such programmes are oftenlaunched without adequate at-tention to the potential prob-lems of real currency appre-

ciation and without a clear exit strategy (i.e. whenand how to alter the peg and/or the regime andrealign the exchange rate). Although economicallyit may appear simple to restore international com-petitiveness by a one-off adjustment in the ex-change rate, this solution may be politically diffi-cult. Indeed, problems in finding a political solu-tion tend to be underestimated. Governments areoften unwilling to abandon the peg and devalueafter exerting considerable effort in attempting toconvince people that the fixed rate has broughtthem more good than harm. They are also afraidof losing markets’ confidence and facing a sharpreversal of capital flows and a collapse of theircurrency.

Given the herd behaviour of financial mar-kets, such fears of a hard landing are not alwaysunfounded, even though, as noted above, sharpcurrency declines rarely result in the return of

Exchange-rate-basedstabilization programmesare often launched withoutadequate attention to thepotential problems of realcurrency appreciation andwithout a clear exit strategy.


rapid inflation. Forewarning an exit strategy isrisky, since it is not always easy to judge how rap-idly inflation will decline. The Turkish exchange-based stabilization programme of December 1999had such a strategy. However, it failed to meet itsinflation target and, after a series of economic andpolitical crises, the Government was obliged toabandon the peg and move to the other corner,floating, before the preannounced exit date (seechapter II, box 2.1). In Europe, institutional arrange-ments in the context of theEMS that involved assistancefrom anchor countries havehelped, on several occasions,to engineer necessary adjust-ments in the currencies of thepegging countries withoutleading to instability and con-tagion (see below). However,such arrangements are not eas-ily replicable for emergingmarkets that peg unilaterally.Support from international financial institutionscould help achieve orderly exits, but the experi-ence so far has not been very encouraging.3

Soft pegs are not used only for disinflation.In East Asia, for example, exchange rate stabilitywas an important ingredient of the export-orienteddevelopment strategy of the individual economiesand was intended to support the regional divisionof labour in the context of the “flying-geese” pro-cess. Because of the concentration of Asian exportsin dollar-denominated markets, nominal exchangerates in the region, although not fixed, had beenkept generally stable within a band of around10 per cent in relation to the dollar since the late1980s. Given their low inflation rates, in most EastAsian economies the appreciation of the currencywas moderate or negligible. The combination ofstable nominal exchange rates, rapid economicgrowth and relatively high nominal interest ratesinspired confidence and attracted internationalinvestors and lenders. However, this led to a build-up of considerable currency risks and externalfinancial fragility, resulting eventually in a rapidexit of capital, with spillover effects throughoutthe region through herd behaviour. Even in Indo-nesia, orderly currency adjustment was notpossible despite sound macroeconomic fundamen-tals and the timely action taken by the Governmentto widen the currency band in order to stop conta-

gious speculation (TDR 1998, Part One, chap. III;Akyüz, 2000b).

One way out of these problems is to use con-trols over capital flows while maintaining a softpeg. Taxes and reserve requirements on inflowsdesigned to remove short-term arbitrage opportu-nities can help preserve monetary autonomy, anda policy of high interest rates can be pursued with-out encouraging speculative capital inflows and a

build-up of excessive currencyrisk. However, as long as do-mestic inflation is high, cur-rency appreciation cannot beavoided. This is particularlyserious when currency pegsare used for disinflation. Inany case, a large majority ofdeveloping countries havebeen unwilling to impose con-trols on capital inflows duringthe boom phase of the finan-

cial cycle, as a means of deterring short-termarbitrage flows, for the same reasons that theywere unwilling to exit from pegged exchange ratesafter successful disinflation. Again, as explainedin the next chapter, they are even less willing toimpose controls over capital outflows in order tostabilize exchange rates and free monetary policyfrom pressures in the currency markets at timesof speculative attacks and crisis.

2. Floating

Does free floating constitute a viable alter-native for developing countries and transitioneconomies? Can such countries really leave theexternal value of their currencies to the whims ofinternational capital flows and dedicate monetarypolicy entirely to domestic objectives such as pricestability or full employment? To what extentwould such objectives be undermined by exces-sive volatility and misalignments associated withfree floating?

Quite apart from how appropriate such a re-gime might be, for a number of reasons it is par-ticularly unsuitable for developing countries andtransition economies, as well as for smaller in-

A large majority ofdeveloping countries havebeen unwilling to imposecontrols on capital inflowsduring the boom phase ofthe financial cycle.


dustrial countries. Compared to the major indus-trial economies, developing and emerging-marketeconomies are much more dependent on foreigntrade, which is typically invoiced in foreign cur-rencies. On average, the share of internationaltrade in their domestic production is twice as largeas in the United States, the EU or Japan, so thatthe impact of exchange rate movements on theirdomestic economic conditions – including prices,production and employment – is much greater.Moreover, these economies have higher net ex-ternal indebtedness, a larger proportion of whichis denominated in foreign currencies. Conse-quently, sharp changes in theirexchange rate tend to gener-ate debt servicing difficulties,liquidity and solvency prob-lems. In sharp contrast, a coun-try such as the United Statescan borrow in its own curren-cy, therefore effectively pass-ing the exchange rate risk ontocreditors.4

It is also argued thatmost developing and transi-tion economies lack credibleinstitutions, and this in itselfis a cause of greater volatility in market sentimentand exchange rates, which is believed to have ledto a widespread “fear of floating” among emerg-ing markets. Consequently, a large number ofthose countries which claim to allow their ex-change rates to float actually pursue intermediateregimes, and use interest rates and currency-mar-ket intervention to influence exchange rates. Thisfinding also contradicts the claim that emergingmarkets have been moving away from adjustablepeg regimes (Calvo and Reinhart, 2000; Fischer,2001; Reinhart, 2000).

The experience of major industrial countrieswith floating rates during the interwar years aswell as since the breakdown of the Bretton Woodssystem suggests that volatility, gyrations and mis-alignments in exchange rates cannot simply be at-tributed to lack of credible institutions. Rather,they are systemic features of currency marketsdominated by short-term arbitrage flows. TheFrench experience in the 1920s, for example, waslucidly described in a report of the League of Na-tions in 1944:

The dangers of such cumulative and self-aggravating movements under a regime offreely fluctuating exchanges are clearlydemonstrated by the French experience of1922–26. Exchange rates in such circum-stances are bound to become highly un-stable, and the influence of psychologicalfactors may at times be overwhelming.French economists were so much impressedby this experience that they developed a spe-cial “psychological theory” of exchangefluctuations, stressing the indeterminatecharacter of exchange rates when left to findtheir own level in a market swayed by specu-lative anticipations … The experience of the

French franc from 1922 to1926 and of such interludesof uncontrolled fluctuationsas occurred in certain cur-rencies in the ’thirties dem-onstrates not only the diffi-culty of maintaining a freelyfluctuating exchange on aneven keel, … it also showshow difficult it may be fora country’s trade balance toadjust itself to wide and vio-lent variations. (League ofNations, 1944: 118, 119)

Writing in 1937 about the same experience, vonHayek explained gyrations not only in terms ofshort-term capital flows; he also argued that float-ing rates encouraged such capital flows:

It is because … the movements of short termfunds are frequently due, not to changes inthe demand for capital for investment, butto changes in the demand for cash as liquid-ity reserves, that short term internationalcapital movements have such a bad reputa-tion as causes of monetary disturbances.And this reputation is not altogether unde-served. … I am altogether unable to see whyunder a regime of variable exchanges thevolume of short term capital movementsshould be anything but greater. Every sus-picion that exchange rates were likely tochange in the near future would create anadditional powerful motive for shiftingfunds from the country whose currency waslikely to fall or to the country whose cur-rency was likely to rise … This means thatif the original cause is already a short-termcapital movement, the variability of ex-changes will tend to multiply its magnitude

The experience of majorindustrial countries withfloating rates suggests thatvolatility, gyrations andmisalignments in exchangerates cannot simply beattributed to lack of credibleinstitutions.


and may turn what originally might havebeen a minor inconvenience into a major dis-turbance. (von Hayek, 1937: 62–64)

As discussed in some detail in earlier UNCTADreports, since the breakdown of the Bretton Woodsarrangements, volatility, per-sistent misalignments and gy-rations have also been thedominant features of the ex-change rates of the major re-serve currencies.5 Despite asignificant convergence of in-flation rates and trends in unitlabour costs during the pastdecade, the G-3 exchange rateshave continued to show per-sistent misalignments and largegyrations. Such disorderly be-haviour has caused serious prob-lems for developing countriesin the management of their currencies and exter-nal debt, and has often been an important factorin major emerging-market crises. But these prob-lems have generally been ignored by the majorindustrial countries which, for the most part, havegeared their monetary policy to domestic objec-tives, notably combating inflation. Only on a fewoccasions have the United States and Japan, forexample, which are committed to free floating,resorted to intervention and ad hoc policy co-ordination when currency instability and mis-alignments posed serious threats to their economicprospects – in the second half of the 1980s, in or-der to realign and stabilize thedollar in the face of mountingprotectionist pressures associ-ated with large trade imbal-ances, and again in the mid-1990s, when the yen rose to un-precedented levels against thedollar.

Developing countries are encouraged toadopt floating on the grounds that the resultingexchange rate uncertainty would remove implicitguarantees and discourage imprudent lending andborrowing. However, experience shows that cri-ses are as likely to occur under floating ratesas under adjustable pegs (World Bank, 1998).Under financial liberalization and free capital mo-bility, nominal exchange rates fail to move in an

orderly way to adjust to differences in inflationrates (i.e. the purchasing power parity is not pre-served), while adjustment of interest rates to in-flation is quite rapid. As a result, currencies ofhigh-inflation countries tend to appreciate over theshort term. Under soft pegs, excessive capital

inflows (i.e. inflows in excessof current-account needs) at-tracted by arbitrage opportu-nities would increase interna-tional reserves, while underfloating, they would lead tonominal appreciations, whichreinforce – rather than temper– capital inflows and aggra-vate the loss of competitive-ness caused by high inflation.Although appreciations alsoheighten currency risks, mar-kets can ignore them whenthey are driven by herd behav-

iour. For instance, if the currencies in East Asiahad been allowed to float in the early 1990s, wheninflows were in excess of current-account needs,the result could have been further appreciationsand widening payments imbalances. Indeed, in theface of such large capital inflows during the early1990s, many governments in East Asia generallychose to intervene in order to prevent apprecia-tion (TDR 1998, box 2).

As already noted, the post-war experience ofemerging markets with floating is rather limited;it is largely concentrated in the aftermath of

recent episodes of financialcrisis. Nevertheless, it revealsa number of features thatbelie the promises of its ad-vocates. In Latin America, forinstance, domestic interestrates have been more sensitiveto changes in United Statesrates, and more variable in

countries with floating regimes than those withfixed or pegged rates, implying less – rather thanmore – monetary autonomy and greater risk to thefinancial system (Hausmann, 1999). Floating ap-pears to promote pro-cyclical monetary policiesas interest rates tend to rise during recession. Italso leads to the shrinking of domestic financialmarkets and to high interest rates by increasingthe risk of holding domestic assets.

Despite a significantconvergence of inflationrates and trends in unitlabour costs during the pastdecade, the G-3 exchangerates have continued toshow persistent misalign-ments and large gyrations.

Crises are as likely to occurunder floating rates asunder adjustable pegs.


3. Hard pegs

It thus appears that emerging-market econo-mies with open capital accounts cannot achievesustained economic and financial stability by ei-ther pegging or floating their currencies. Thereremain the options of hard pegs, currency boardsor outright dollarization. At the end of the 1990s,the currencies of 45 economies, members of theIMF, had hard pegs, of which 37 (including thethen 11 euro-currency coun-tries) had no independent le-gal tender, and the remainder(including Argentina, HongKong (China) and the transi-tion economies of Bulgaria,Estonia and Lithuania) hadcurrency boards(Fischer, 2001).With the exception of EMU,most economies without an in-dependent legal tender weresmall. More recently, Ecuadorand El Salvador have adoptedthe dollar as their national cur-rency and Guatemala is in theprocess of doing so.

Such regimes are considered particularly ap-propriate for countries with a long history of mon-etary disorder, rapid inflation and lack of fiscaldiscipline (i.e. where there is “exceptional distrustof discretionary monetary policy”) (Eichengreen,1999: 109). They effectively imply abolishing thecentral bank and discarding discretionary mon-etary policy and the function of lender of last re-sort. Not only do they remove the nominal ex-change rate as an instrument of external adjust-ment, but also they subordinate all other policyobjectives to that of maintaining a fixed nominalexchange rate or dollarization. However, thesesame features also provide the credibility neededfor the success of such regimes since they implythat governments are prepared to be disciplinedby external forces, particularly by a foreign cen-tral bank with a record of credible monetarypolicy. The expected economic benefits includelow inflation, low and stable interest rates, lowcost of external borrowing and, if there is outrightdollarization, the ability to borrow abroad in thecurrency circulating domestically. Furthermore,dollarization is expected to deepen the financial

sector, extend the maturities of domestic finan-cial assets and encourage long-term financing. Itis often favoured by private business in emergingmarkets because it increases predictability andreduces the cost of transactions.

Some of these benefits can be significant. Fora small economy which is closely integrated with,and dependent on, a large reserve-currency coun-try such benefits may also offset the potential costsof no longer being able to use interest and ex-

change rates in response to do-mestic and external shocks,and to manage business cy-cles as well as the loss of sei-gniorage from printing money.However, for most developingcountries, currency boards anddollarization are not viable al-ternatives over the long term,even though they may help toquickly restore credibility af-ter a long history of monetarydisorder, fiscal indisciplineand rapid inflation. In particu-lar, large and unpredictablemovements in the exchangerates of major reserve curren-

cies make the option of unilaterally locking intoand floating with them especially unattractive.6

Hard pegs do not insulate economies fromexternal financial and real shocks, any more thandid the gold standard. Unless the anchor countryexperiences very similar shocks and responds ina manner that is also appropriate to the anchoringcountry, the costs of giving up an independentmonetary policy and defending a hard peg can bevery high in terms of lost output and employment.But for obvious structural and institutional rea-sons, a combination of developing and industrialcountries does not constitute an optimal currencyarea, and they are often subject to asymmetricshocks, especially if the developing countries arehighly dependent on primary exports. Further-more, in the absence of close economic integra-tion, the business cycles of anchor and anchoringcountries are unlikely to be synchronized, so thata particular monetary policy stance pursued by theformer may be unsuitable for the latter. Thus, acountry with a hard peg may find its currency andinterest rates rising at a time when its economy is

Not only do hard pegsremove the nominalexchange rate as aninstrument of externaladjustment, but also theysubordinate all other policyobjectives to that ofmaintaining a fixed nominalexchange rate ordollarization.


already suffering from recession and loss of com-petitiveness in international markets, as Argentinahas over the past two years (see chapter II, box 2.2).

It is often suggested that asymmetric shocksand asynchronous cycles do not matter as longas wages and prices are fullyflexible. In this respect, thereis a certain degree of ambiva-lence in the orthodox thinkingon exchange rate policy, sinceone of the original argumentsin favour of floating rates wasthat sticky wages and pricesprevented rapid adjustment tointernal and external shockswithout sacrificing growth andemployment (Friedman, 1953).Even when wages and pricesare reasonably flexible, the ad-justment process can entaillarge costs because it is not instantaneous. Withan absolutely fixed exchange rate, the only instru-ment at hand to correct real appreciation is a cutin nominal wages, but that cannot be achievedwithout reducing aggregate domestic demand andincreasing unemployment. Furthermore, for thereasons explained by Keynes more than 60 yearsago, such cuts, will, in turn, reduce aggregate de-mand and add to deflationary pressures when theyresult in lower real wages. Thus it would be verydifficult to restore competitiveness without defla-tion. Fiscal austerity designed to reduce externaldeficits would only deepen the crisis, leading towhat Robert McKinnon described nearly 40 yearsago as a situation of the “tail wagging the dog”(McKinnon, 1963: 720). It is therefore surprisingthat the most important argument advanced infavour of flexible exchange rates, namely the slug-gishness of nominal wage and price adjustment,is overlooked by the advocates of currency boardsor dollarization.

Nor can currency boards ensure that domes-tic interest rates remain at the level of the countryto which the currency is pegged. When the econo-my suffers from loss of competitiveness and largepayments deficits, the resulting decline in reservesleads to a reduction in liquidity, pushing up inter-

est rates and threatening to destabilize the bank-ing system. It has indeed been shown that a cur-rency board regime makes payments crises lesslikely only by making bank crises more likely(Chang and Velasco, 1998). International inves-tors may not take the hard peg for granted and

may demand a large risk pre-mium, as demonstrated by thelarge spreads that most curren-cy board countries have had topay over the past few years.Speculative attacks againsta currency can occur in a cur-rency board system as in anyother exchange rate regime,and costs incurred in defend-ing a hard peg may exceedthose incurred by countries ex-periencing a collapse of softpegs. For instance, in terms ofloss of output and employ-

ment, Argentina and Hong Kong (China) sufferedas much as or even more than their neighbourswhich experienced sharp declines in their curren-cies during recent emerging-market crises. For fi-nancially open economies, differences among suchregimes are due less to their capacity to preventdamage to the real economy and more to the waydamage is inflicted.

Historically, exits from currency boards haveoccurred in the context of decolonization, whenthe pound sterling was often the anchor currency.Unlike their modern counterparts, the rationale forestablishing such regimes was not to gain cred-ibility; rather, they were imposed by the colonialpower with a view to reinforcing trade ties withits colonies. In principle, by retaining a nationalcurrency, currency board regimes – as distinctfrom dollarization – allow for devaluation andeven exit. However, there is no modern currencyboard regime with a known exit strategy; indeed,making such a strategy known would defeat itsvery purpose. For this reason, an orderly exit froma currency board regime is unlikely to be possible,especially when the economic costs of adhesionmilitate in favour of change. By contrast, whenthe regime works well, governments feel no needfor exit.

A currency board regimemakes payments crisesless likely only by makingbank crises more likely, andcosts incurred in defendinga hard peg may exceedthose incurred by countriesexperiencing a collapse ofsoft pegs.


Given the difficulties that developing coun-tries have been facing in finding unilateral solu-tions to the problem of managing their currenciesand preventing financial crises, and given theresistance of the major powers to genuine reformof the international financial architecture, atten-tion has increasingly focused on regional solutions(Chang, 2000; Mistry, 1999; Park and Wang, 2000).In this context, there is growing interest in the les-sons provided by the Europeanexperience with regional mon-etary cooperation and curren-cy arrangements in the post-Bretton Woods era, which cul-minated in a monetary unionat the end of the 1990s.

The first response of Eu-rope to the collapse of theBretton Woods system inthe early 1970s consisted of“snake” and “snake in the tun-nel” arrangements that weredesigned to stabilize the intra-European exchange rates with-in relatively narrow bands inan environment of extreme volatility. This wasfollowed by the creation of the EMS in 1979 withthe participation of the members of the EuropeanEconomic Community (EEC), and eventually bythe introduction of the euro and the establishmentof the European Monetary Union (EMU) in 1999.7

Thus it took some 30 years to pass from soft pegsto hard pegs.

After the collapse of the Bretton Woods sys-tem, European countries were able to avoid infla-tionary spillovers from the United States by ap-

preciation of their currencies vis-à-vis the dollar,and floating against the dollar was seen as con-sistent with their objective of stabilizing the in-ternal value of their currencies. However, giventhe relatively high degree of regional integration,a move towards free floating among the Europeancurrencies posed a potential threat of instabilityand disruptions to intraregional trade and resourceallocation, particularly for small and open econo-

mies. A policy of establishinga stable pattern of intraregion-al exchange rates and collec-tively floating against the dol-lar was seen as an appropriatesolution, since the trade of theregion as a whole with the restof the world was relatively small.In effect, regional integrationand monetary cooperation wasdesigned to establish Europeas a single large economy –like that of the United States– with limited dependence oninternational (extra-European)trade.

Although the decision to join such arrange-ments (or, in the Austrian view, to “tie their ownhands” in monetary affairs) was taken unilater-ally by each country, the system that emergedinvolved multilateral commitments at the regionallevel. Since the deutsche mark had been the moststable currency after the war and Germany wasthe largest market in the region, the Germancurrency provided a natural anchor for manyEuropean countries following the collapse of theBretton Woods arrangements. Given the politicalwill of the participating countries to move towards

C. Regional arrangements: the European experience

Although the smallerEuropean countriessacrificed part of theirmonetary autonomy, theywere considerablystrengthened vis-à-viscurrency markets andbecame less dependent oninternational financialinstitutions.


greater integration, Germany did not simplyprovide an anchor currency; it also assumed re-sponsibilities vis-à-vis the anchoring countries insecuring the stability of thearrangements through suchmeans as intervention in thecurrency markets and provi-sion of lender-of-last-resortfinancing, although the latterrole has never been explicitlystated. As for the smallercountries, although they sac-rificed part of their monetaryautonomy, they were consid-erably strengthened vis-à-viscurrency markets and becameless dependent on interna-tional financial institutions.

In the process leading to a common currency,the adjustable pegs adopted were crucially differ-ent from the unilateral soft pegs used by emergingmarkets in recent years in that both anchoring andanchor countries shared the common objective ofachieving monetary convergence and internal andexternal stability for their currencies. The systemwas also designed to reduce one-way bets, whichmight have been encouraged by inflation and in-terest rate differentials, by establishing bandsaround the so-called “parity grids”. It establishedobligations for symmetric interventions as well asunlimited short-term credit facilities among cen-tral banks designed to maintain bilateral exchangerates within the band. It also made available tomember countries various types of external pay-ments support to enable ERM participants both tokeep their currencies within prescribed fluctua-tion limits and to cope with circumstances thatmight threaten orderly conditions in the marketfor a member country’s currency.8 In addition, itstipulated concrete procedures for realignment ofthe bands. Furthermore, European integration al-lowed special arrangements in the ERM for theless advanced countries – Greece, Ireland, Portu-gal and Spain – including the provision ofconsiderable fiscal compensation, which did muchto enable them to achieve monetary and fiscalconvergence and meet the EMU stability criteria.

These arrangements were also supported bya European Community regime for capital move-ments, which, until a directive in 1988, provided

governments with some leeway for restricting dif-ferent categories of transaction, along with someliberalization obligations which were less strin-

gent for short-term and poten-tially speculative transactions.The 1988 directive abolishedrestrictions on capital move-ments between residents ofEuropean Community coun-tries, subject to provisos con-cerning the right to controlshort-term movements duringperiods of financial strain.9

The directive also stated thatEuropean Community coun-tries should endeavour to at-tain the same degree of liber-alization of capital movementsvis-à-vis third countries as

among themselves. However, governments re-tained the right to take protective measures withregard to certain capital transactions in responseto disruptive short-term capital movements. Uponadoption of the single currency, such measurescould be taken only in respect of capital move-ments to or from third countries.

Despite the establishment of institutions tosupport the exchange rate arrangements and inte-gration, the path to monetary union has not beensmooth; it has often been disrupted by shocks andpolicy mistakes. In some instances disruptionswere similar to currency crises experienced byemerging markets under soft pegs. As in emerg-ing markets, occasionally pressures developed asa result of differences in the underlying inflationrates: at the high end of the inflation spectrum wasItaly (and subsequently the United Kingdom), fol-lowed by France with moderate inflation, whileGermany and Austria were at the lower end. Forhigh-inflation countries, therefore, currency re-alignments were needed from time to time untiltheir inflation rates converged towards that of theanchor country. On many occasions inflation dif-ferentials were widened by external or internalshocks which, in effect, tested the resilience ofthe system and the commitments of the partici-pating countries to internal and external stability.The first shock came soon after the collapse ofthe Bretton Woods arrangements in the form of ahike in oil prices. In the United Kingdom and Italyunit labour costs rose much faster, and inflation

Currency arrangementswere also supported by aEuropean Communityregime for capitalmovements, which, until adirective in 1988, providedgovernments with someleeway for restrictingdifferent categories oftransaction.


persisted longer than in France, Austria and Ger-many (chart 5.1). In consequence, the paritiesbetween the currencies of these countries becameunsustainable, necessitating realignments.

However, such realignments have not alwaysbeen an orderly process. The events leading to the1992–1993 EMS crisis provide useful lessons onhow regional currency arrangements, even withsupporting institutions, can break down when ex-change rates are inconsistent with underlyinginflation and interest rates. The beginning of thiscrisis originated from the policy response to the1987 global stock market crash, when centralbanks in the United States and Europe loweredinterest rates to historical lows. This provided astrong monetary stimulus at a rather late stage ofrecovery, pushing up growth rates in Europe to4 per cent or higher, with the United Kingdomleading in the late 1980s and Germany in the early1990s (owing also to the impact of unification).Acceleration in growth, however, was associatedwith greater divergence of inflation rates; unit la-bour costs went up drastically in Italy and theUnited Kingdom, compared to Germany andFrance (chart 5.2). However, the nominal ex-change rate of the lira against the deutsche markwas kept virtually stable from 1987 until 1992,implying a real appreciation of 23 per cent. Forthe United Kingdom, which had entered the ERMin 1990 with an already overvalued currency, therate of appreciation was even higher. In both coun-tries, loss of competitiveness was reflected in asharp swing in the current account from a surplusto a deficit. Until the outbreak of the crisis, thesedeficits were sustained by large inflows of capi-tal, notably from Germany, on account of sizeableinterest rate differentials. Thus the EMS crisis thatforced Italy and the United Kingdom to leave ERMand devalue in September 1992 was similar inmany respects to emerging-market crises. Forthese two countries, such an adjustment in nomi-nal rates was certainly preferable to maintainingthe grids and trying to restore competitivenessthrough a deflationary adjustment. By contrast,as discussed in TDR 1993 (Part Two, chap. I,sect. B), the attack on the French franc could notbe depicted as a case of the market eventuallyimposing discipline, because the underlying fun-damentals of the French economy were as strongas those in Germany.

Chart 5.1

UNIT LABOUR COSTS IN SELECTEDEUROPEAN COUNTRIES AFTERA NEGATIVE SUPPLY SHOCK,

1972–1976

(Per cent change over previous year)

Source: AMECO database, European Commission, 2000.

Chart 5.2

UNIT LABOUR COSTS AFTER A POSITIVEDEMAND SHOCK, 1987–1991

(Per cent change over previous year)

Source: See chart 5.1.

1972 1973 1974 1975 1976

Pe

rce

nt

ch

an

ge

ove

rp

revio

us

ye

ar

35

30

25

20

15

10

5

0

United Kingdom

Italy

France

Austria

Germany

Per

centchange

ove

rpre

vio

us

year

10

9

8

7

6

5

4

3

2

1

0

United Kingdom

Italy

France

Austria

Germany

1987 1988 1989 1990 1991


This experience shows that, just as with uni-lateral pegging or fixing, regional currency ar-rangements, even with supporting institutions, canrun into trouble in the absence of appropriatepolicy actions to bring exchange rates into con-formity with underlying fundamentals. Again,while it is true that the hegemony of an anchor coun-try in regional arrangements is balanced by respon-sibilities that are not present in unilateral pegging orfixing, policies pursued by such a country may stillturn out to be too restrictive for other members. In-deed, tight German monetary policy appears tohave been a factor in the speculative attack on theFrench franc during the EMS crisis.

With the move to a single currency, smallermembers of the EMU are expected to exert a some-

what greater influence on the common monetarypolicy. Furthermore, strong trade linkages can bea force for stability and convergence, with expand-ing economies providing additional demand andexport markets for those members experiencing adownturn. Even though asymmetric shocks andstructural differences may still produce significantdivergence of economic performance among coun-tries at different levels of development, suchdifferences do not need to cause serious policydilemmas if countries are prepared to use the vari-ous instruments they still have at their disposal.However, under certain circumstances, the con-straints imposed on fiscal policy by the Stabilityand Growth Pact could impair the ability to smoothout intraregional differences in economic perform-ance.

D. Options for developing countries:dollarization or regionalization?

Despite the temporary setbacks in 1992–1993,and shortcomings in the design of policies andinstitutional arrangements which constrainedpolicy options, European monetary cooperationhas been successful in securing stability in intra-regional exchange rates, containing financialcontagion and dealing with fluctuations vis-à-visthe dollar and the yen. To what extent can such ar-rangements be replicated by developing countriesas a means of collective defence against systemicinstability? Is it feasible for developing countries toestablish regional arrangements among themselveswithout involving G-3 countries, and to follow apath similar to that pursued by Europe – from aregionally secured exchange rate band to a cur-rency union? Alternatively, could they go directlyto currency union by adopting a regional currency?

Interest in regional monetary arrangementsand cooperation in the developing world has in-creased rapidly since the outbreak of the Asiancrisis. For example, at the 1997 Annual Meetingsof the IMF and the World Bank, soon after theoutbreak of the crisis, a proposal was made to es-tablish an Asian Monetary Fund. Subsequently,an initiative was launched in May 2000 involvingswap and repurchase arrangements among mem-ber countries of the Association of South-EastAsian Nations (ASEAN), China, Japan and theRepublic of Korea (see box 5.1). More recently, thejoint French-Japanese paper cited in section Aabove (Ministry of Finance, Japan, 2001: 5–6) hasgiven support to the strengthening of regional co-operation in East Asia, drawing on the Europeanexperience:


Box 5.1

REGIONAL MONETARY AND FINANCIAL COOPERATION AMONG DEVELOPING COUNTRIES

At present there are few regional financial and monetary arrangements among developing coun-tries, apart from those in East Asia described in box 5.2. Such arrangements as do exist range fromagreements to pool foreign exchange reserves, such as the Andean Reserve Fund and the ArabMonetary Fund, to currency pegging (Rand Monetary Area) and a regional currency (Eastern Carib-bean Monetary Union). The Communauté financière africaine (CFA) also has a common currency,but is unique in that it involves an agreement between its members and a major European countryon cooperation in monetary and exchange-rate policy.

The Andean Reserve Fund was established in 1976 by the members of the Andean Community –Bolivia, Colombia, Ecuador, Peru and Venezuela – and has a subscribed capital of $2 billion. TheFund provides financial support to its members in the form of loans or guarantees for balance-of-payments support, short-term (liquidity) loans, emergency loans, loans to support public externaldebt restructuring, and export credit. Conditionality for drawing on these facilities is softer thanthat of IMF. The Fund also aims at contributing to the harmonization of the exchange-rate, mon-etary and financial policies of member countries. It is thus intended to promote economic andfinancial stability in the region and to further the integration process in Latin America.1

The Arab Monetary Fund was established in 1976 with a structure similar to that of IMF andcomprises all members of the League of Arab States (except the Comoros). It has a subscribedcapital of 326,500 Arab accounting dinars, equivalent to about $1.3 billion. The Fund aims atpromoting exchange-rate stability among Arab currencies and at rendering them mutually convert-ible, and it provides financial support for members that encounter balance-of-payments problems.It is also intended to serve as an instrument to enhance monetary policy cooperation among mem-bers and to coordinate their policies in dealing with international financial and economic prob-lems. Its final aim is to promote the establishment of a common currency.

In the Rand Monetary Area, Lesotho and Swaziland, both economically closely integrated withSouth Africa, peg their currencies to the South African rand without formally engaging in coordi-nation of monetary policy.

The Eastern Caribbean Monetary Union is an arrangement for a common currency among themembers of the Organization of Eastern Caribbean States, a group of small island developingcountries.2 The currency is pegged to the dollar, but in contrast to France with respect to the CFA(see below), the United States does not play an active role in the pegging arrangement.

The creation of the Communauté financière africaine goes back to 1948, but the agreements gov-erning the current operation of the CFA-zone were signed in 1973. There are two regional groups,each with its own central bank: the Economic and Monetary Union of West Africa, and the CentralAfrican Economic and Monetary Community.3 The 14 countries involved have a common cur-rency, the CFA franc, that is not traded on the foreign exchange markets but is convertible with theFrench franc at a fixed parity. There is free capital mobility within the CFA-zone, and betweenthese countries and France, and the foreign exchange reserves of its members are pooled. TheFrench Treasury guarantees the convertibility of the CFA franc into French francs at a fixed parity andassumes the role of lender of last resort. On the other hand, the arrangement includes a mechanismthat limits the independence of the two regional central banks, and the French Treasury can influ-ence monetary policy in the CFA zone as well as determination of the parity with the French franc.

Each of the two central banks has an operations account with the French Treasury into which theyhave to deposit 65 per cent of their foreign exchange reserves, but which also provides an overdraftfacility (at market-related interest) that is, in principle, unlimited. On the other hand, in their op-erations the central banks have to observe two rules that are designed to check the supply of CFAfrancs: (i) their sight liabilities are required to have a foreign exchange cover of at least 20 per


cent, and (ii) their lending to each member Government is limited to 20 per cent of that Government’srevenue of the previous year. Moreover, France has seats on the Boards of both central banks.4

It appears that membership in the CFA has helped to keep inflation in the CFA countries concernedconsiderably below the average of other African countries; between 1975 and 1985, per capitaincome also grew faster. However, the system came under increasing strain after 1985 due to exter-nal shocks and weakening macroeconomic fundamentals (Hadjimichael and Galy, 1997). The CFAcountries suffered from severe terms-of-trade losses as world market prices for some of their majorexport commodities (cocoa, coffee, cotton and oil) dropped sharply and the French franc appreci-ated markedly against the dollar following the Plaza Accord of 1985. Consequently, the nominaleffective exchange rate of the CFA franc rose by almost 7 per cent annually between 1986 and1993. CFA countries’ exports lost competitiveness in world markets as domestic costs could not bereined in; both the combined current-account and the fiscal deficit of the CFA zone increased by6.5 per cent of GDP, and the 20 per cent limit of monetization of government debt was substan-tially exceeded by several countries.

In 1994 it was decided to adjust the parity of the CFA franc with the French franc, from 50 CFAfrancs to 100 CFA francs to one French franc (see also TDR 1995, chap. 1, box 1; Clément, 1996).This was the first – and so far only – devaluation since 1948, but it demonstrated the vulnerabilityof the arrangement, especially in the absence of a mechanism that would allow for a gradual ad-justment of the nominal exchange rate in the light of macroeconomic and balance-of-paymentsdevelopments. The probability that these developments diverge between commodity-dependentdeveloping countries and the developed country whose currency serves as an anchor is relativelyhigh, given the difference in their exposure to external shocks.

The stability and proper alignment of exchange rates of the CFA countries vis-à-vis their tradepartners and competitors exert a major influence on their overall economic performance. First,trade in these countries accounts for a very high share of GDP. Second, intra-CFA trade is limited,accounting, on average, for only 8 per cent of its members’ total trade.5 Third, because of structuraldifferences, CFA and EU countries do not constitute an optimal currency area. Even though half ofthe total trade of CFA countries is with the EU, their export and import structures are very differentand the CFA countries face competition from third parties in commodity exports both to the EUand elsewhere. Thus, while bringing a certain amount of monetary discipline and protection againstspeculative attacks, a policy of locking into the French franc (and, hence, subsequently into theeuro) and floating with it against other currencies poses problems for trade and international com-petitiveness.

1 For more detailed information, see FLAR (2000).2 The member States are Antigua and Barbuda; Dominica; Grenada; Montserrat; St. Kitts and Nevis; Saint

Lucia; and St Vincent and the Grenadines. The British Virgin Islands and Anguilla are associate members.3 The Economic and Monetary Union of West Africa comprises Benin, Burkina Faso, Côte d’Ivoire, Guinea-

Bissau, Mali, Niger, Senegal and Togo; and the Central African Economic and Monetary Communitycomprises Cameroon, Central African Republic, Chad, Congo, Equatorial Guinea and Gabon. The twogroups maintain separate currencies, but since both have the same parity with the French franc, they aresubject to the same regulatory framework. And because there is free capital mobility between each ofthe two regions, the CFA franc zone can be considered as a single currency area. The Comoros has asimilar arrangement but maintains its own central bank.

4 For a detailed treatment of the institutional aspects of the CFA, see Banque de France (1997).5 Trade with countries within the CFA franc zone ranges from 1.5 per cent of total trade in Congo to

23.3 per cent in Mali. By contrast, trade links with Europe are very close. They are slightly closer forthe member States of the Central African Economic and Monetary Community (50 per cent of exportsand 66 per cent of imports) than for the members of the Economic and Monetary Union of West Africa(49.3 and 46.3 per cent, respectively).

Box 5.1 (concluded)


Strengthened regional co-operation is a wayof ensuring both stability and flexibility …The European Monetary Union process pro-vides a useful example of how furtherintegration can be achieved … In this re-gard, an important step was taken in ChiangMai on 6 May 2000 to establish a regionalfinancial arrangement to supplement exist-ing international facilities … Regionalco-operation frameworks should be fully in-tegrated into the overall monetary andfinancial system.

Interest has also been expressed in establishingregional currencies, as opposed to dollarization,in Latin America. A recent statement made by thePresident of the Inter-American DevelopmentBank stated:

The issue (of dollarization) is very contro-versial and has both its defenders anddetractors, but we do not think the condi-tions are appropriate in most countries fortaking that route … We believe, however,that the important conditions are in place forthinking about sub-regional currencies.(Reported in SUNS, 11 January 2000.)

If established and sustained, regional curren-cies among developing country groupings canbring considerable benefits, similar to those ex-pected from the introduction of the euro. They canreduce transaction costs of doing business withina region and eliminate exchange rate spreads andcommissions in currency trading associated withintraregional trade and investment. For example,such effects are estimated toraise the combined GDP of theeuro area by some 0.5 per cent.The adoption of the euro isalso expected to raise intrare-gional trade, primarily throughtrade diversion (TDR 1999,Part One, chap. III). Further-more, a supranational centralbank can reduce the influenceof populist national politics onmonetary policy, while never-theless being accountable tomember countries. Unlike dol-larization, such an arrangement would also bringbenefits in terms of seigniorage (Sachs and Larrain,1999: 89).

Establishing regional arrangements – includ-ing regional currencies – among developingcountries would also reduce the likelihood of syn-chronous cycles and asymmetric shocks to theextent that there are similarities in their economicstructures and institutions. In other words, a group-ing of developing countries alone is more likelyto meet the conditions of an optimal currency areathan one which also involves developed countries.

However, in drawing lessons from Europe fordeveloping countries, it is necessary to take intoaccount certain differences between the two. TheEuropean experience shows that small and highlyopen economies with close regional trade links canestablish and sustain a system of stable exchangerates around a major reserve currency so long asthere are clear guidelines regarding the mainte-nance and alteration of members’ currency bands,appropriate allocation of responsibilities and sup-porting institutions and policies. Such arrange-ments can be operated for quite a long timewithout major disruptions and can help to deepenintegration (see box 5.2). For larger groups andfor countries of equal size or economic power,however, there could be significant difficulties inestablishing and sustaining such systems. Therewould be an additional difficulty when the groupdoes not contain a major reserve-currency country.

Consequently, unless they are organizedaround a major reserve-currency country, devel-oping countries of comparable size may find itdifficult to form a group to establish and sustainERM-type currency grids and ensure that the

monetary and financial poli-cies pursued independentlyby each country are mutuallycompatible and consistent withthe stability of exchange rates.Moreover, without the involve-ment of a large reserve-currencycountry, it could be difficult toput in place effective defencemechanisms against specu-lative attacks on individualcurrencies. Under these condi-tions, while a rapid move tomonetary union through the

adoption of a regional currency might be consid-ered desirable, it would face similar problems ofimplementation as the introduction of an exchange

Is it feasible for developingcountries to establishregional currencyarrangements amongthemselves withoutinvolving G-3 countries,and to follow a path similarto that pursued by Europe?


Box 5.2

THE CHIANG MAI INITIATIVE

Even before the financial crisis of 1997, there had been a growing interest in East Asia inpursuing regional policy coordination and monetary cooperation. Various swap arrange-ments and repurchase agreements had been introduced, and these initiatives intensified dur-ing the Mexican crisis in the mid-1990s. However, none of these moves prepared the regionfor the currency runs of 1997 and 1998.

In a Joint Statement on East Asia Cooperation issued at the summit of “ASEAN plus 3” (the10 members of ASEAN plus China, Japan, and the Republic of Korea) in November 1999, itwas agreed to “strengthen policy dialogue, coordination and collaboration on the financial,monetary and fiscal issues of common interest” (Ministry of Finance, Japan, 2000a: 8).Against this background, the region’s Finance Ministers launched the so-called “ChiangMai Initiative” in May 2000, aimed at building networks for multilayered financial coop-eration to match the growing economic interdependence of Asian countries and the conse-quently greater risk that financial shocks could lead to regional contagion.1 The Initiativeenvisages the use of the ASEAN+3 framework to improve exchange of information on capi-tal flows and to launch moves towards the establishment of a regional economic and finan-cial monitoring system. The core of the Initiative is a financing arrangement among the13 countries that would strengthen the mechanism of intraregional support against currencyruns. This arrangement, building on the previous ASEAN Swap Arrangement (ASA), isintended to supplement existing international financial cooperation mechanisms. It is alsoexpected to contribute to the stability of exchange rates within the region.

The previous ASA, which dates back to 1977, comprised only five countries (Indonesia,Malaysia, the Philippines, Singapore, and Thailand). Total funds committed under the ar-rangement were $200 million – a negligible amount compared to the combined loss of for-eign exchange reserves of $17 billion that the five countries experienced between June andAugust 1997.

The new ASA envisaged under the Chiang Mai Initative includes Brunei Darussalam andallows for the gradual accession of the four remaining ASEAN countries (Cambodia, LaoPeople’s Democratic Republic, Myanmar and Viet Nam). But its most important element isthe inclusion of bilateral swap and repurchase arrangements between the ASEAN countriesand China, Japan, and the Republic of Korea. Funds available under the new ASA total$1 billion. However, the commitments of the three non-ASEAN countries to the bilateralswap arrangements are likely to be substantially greater than this; they will be determinedby the level of their foreign currency reserves and the amounts that were involved in earlieragreements between Japan and the Republic of Korea ($5 billion) and Japan and Malaysia($2.5 billion). The conditions for drawing on the facilities and a number of technicalitiesremain to be agreed in negotiations among the countries concerned, but it appears that as-sistance under the bilateral swap arrangements will, in principle, be linked to IMF support(Ministry of Finance, Japan, 2000b).

1 For further information on the Initiative, see Ministry of Foreign Affairs of the Kingdom ofThailand (2000); Ministry of Finance, Japan (2000a and 2000b); “Asia finance: Central banksswap notes”, The Economist, 16 May 2000.


rate mechanism. Recognition of such difficultiesand adoption of appropriate mechanisms to over-come them are essential if developing countries areto succeed in their attempts to form regional mon-etary groupings aimed at attaining greater ex-change rate and financial stability.

The absence of a major reserve-currencycountry in regional arrangements also poses prob-lems of credibility. It may be especially difficultfor countries with a long history of monetary dis-order and inflation to form a credible monetaryunion without involving a major reserve-currencycountry with a good record of monetary disciplineand stability. In this regard, Latin America isclearly less favourably placed than East Asia.

More fundamentally, for developing coun-tries to manage on their own regional exchangerates vis-à-vis the G-3 currencies is a dauntingtask, whether it is undertaken within the frame-work of a monetary union or under ERM-typearrangements. They cannot simply float their cur-rencies and adopt an attitude of benign neglecttowards the value of their cur-rencies vis-à-vis the rest of theworld, even under conditionsof deep regional integration.For instance, in East Asia,while intraregional tradeamong the countries of theregion (ASEAN, first-tier NIEsand China) is important andconstantly growing, it stillaccounts for less than half oftheir total trade (TDR 1996,Part Two, chap. I, sect. E),compared to two thirds in theEU. Furthermore, as a propor-tion of GDP, the trade of EastAsian developing countries with the rest of theworld is more than twice as large as that of theUnited States, the EU or Japan. Accordingly, theirexchange rates vis-à-vis G-3 currencies can exerta considerable influence on their economic per-formance. Furthermore, regional arrangementswould not protect them against financial shocks,since they carry large stocks of external debt inG-3 currencies.

These factors thus render floating against G-3currencies unattractive and raise the question of

what constitutes an appropriate exchange rate re-gime at the regional level. One option is toestablish a crawling band, with the central ratedefined in terms of a basket of G-3 currencies.10

The joint French-Japanese paper cited above sug-gested that such an intermediate regime could bea possible step towards monetary union:

A possible solution for many emerging mar-ket economies could be a managed floatingexchange-rate regime whereby the currencymoves within a given implicit or explicitband with its centre targeted to a basket ofcurrencies. … managed free-floating ex-change rate regimes may be accompaniedfor some time, in certain circumstances, bymarket-based regulatory measures to curbexcessive capital inflows. (Ministry of Fi-nance, Japan, 2001:3–4)

The paper went on to argue that a “group ofcountries with close trade and financial linksshould adopt a mechanism that automaticallymoves the region’s exchange rates in the samedirection by similar percentages”. This would im-

ply fixed bands for currenciesof members, as in the ERM.But as the European experi-ence shows, there would alsobe a need to alter such bandsin line with changes in infla-tion rates, for example. Sucha regime, pursued collectively,may need to be supported bya collective system of controlover capital movements. Forreasons already mentioned,control over capital flows –both inward and outward – canbe more easily agreed uponwhen countries act together

rather than separately. In such an arrangement,intraregional capital flows may be deregulated –as in the EMU – but capital flows to and from non-member countries would have to be controlled –as in the formative years of the EMS – in order torestrict short-term, potentially destabilizing move-ments.

Any regional monetary arrangement wouldneed to include mechanisms to support the re-gional currency, or currencies, in order to keepexchange rates in line with targets and stem specu-

For developing countries tomanage on their ownregional exchange ratesvis-à-vis the G-3 currenciesis a daunting task, whetherit is undertaken within theframework of a monetaryunion or under ERM-typearrangements.


lative attacks. Since the East Asian crisis, variousproposals have been put forward to establish re-gional support mechanisms for intervention incurrency markets and for theprovision of international li-quidity to countries facing arapid exit of capital. The 1997proposal to establish an Asianfacility of $100 billion was“derailed quickly by theUnited States Treasury andIMF for fear that it would de-tract from the role (and power)of the latter and make it evenmore difficult to get the UnitedStates’ contribution to theIMF’s latest quota increaseauthorized by the United States Congress” (Mistry,1999: 108).11 Another proposal made was to pooland deploy national reserves to defend currenciesfacing speculative attacks and to provide interna-tional liquidity to countries without the stringentconditions typically attached to such lending byinternational financial institutions. For instance onthe eve of the Thai crisis in 1997, the combinednet reserves of East Asia – including Japan – ex-ceeded $500 billion, and by 2000 had risen toabout $800 billion (Park andWang, 2000). Pooling of reservescan also be supplemented byregional agreements to borrowamong regional central banks,modelled on the IMF’s GeneralArrangements to Borrow (GAB),as recently proposed by Sin-gapore as a form of mutual as-sistance.

Arrangements such aspooling of national reserves orswap facilities among centralbanks can undoubtedly domuch to stabilize exchangerates, even when they involveonly developing countries of the region. However,they are likely to be more effective in smoothingout short-term volatility and responding to isolatedcurrency pressures than in stalling systemic crises.Given the herd behaviour of financial markets, thespeed of spillovers and extent of contagion, it maybe impossible to sustain an ERM-type currencyband at times of crisis simply by drawing on a

pool of national reserves, if there is no possibilityof recourse to a regional lender of last resort. Be-sides, maintaining a high level of reserves for this

purpose would be a very ex-pensive way of securing insur-ance against financial panics.As discussed in the next chap-ter, a more viable alternativewould be to resort to unilateralstandstills and exchange andcapital controls at times ofspeculative attacks.

In a world of systemicand global financial instabil-ity, any regional arrangementdesigned to achieve exchange

rate stability in order to prevent crises, and man-age them better if they nonetheless occur, shouldalso incorporate a number of other mechanisms,with the aim of ensuring enhanced regional sur-veillance, information-sharing and early warning.Domestic reforms would still be needed in manyof the areas discussed in the previous chapter inorder to provide a sound basis for regional coop-eration. Just as domestic policy actions withoutappropriate global arrangements would not be

sufficient to ensure greater fi-nancial stability, regional ar-rangements could fail in theabsence of sound domestic in-stitutions and policies.

As European experiencehas shown, progress towardsa currency union can be a longand drawn-out process, requir-ing political will and a “cul-ture” of regionalism. Regionalmonetary arrangements link-ing several national currenciesthrough exchange rate bandscan encounter serious prob-lems even when there are sup-

porting institutions. It would not be easy for de-veloping countries to replicate the Europeanexperience, with or without the help of G-3 coun-tries. However, the threat of virulent financialcrises, together with the lack of genuine progressin the reform of the international financial archi-tecture, has created a sense of urgency in emerg-ing markets, notably in East Asia, for building col-

Any regional monetaryarrangement would need toinclude mechanisms tosupport the regionalcurrencies in order to keepexchange rates in line withtargets and stemspeculative attacks.

As European experiencehas shown, progresstowards a currency unioncan be a long and drawn-out process, requiringpolitical will and a “culture”of regionalism. Recentinitiatives and proposals inEast Asia, however modestthey may be, constitute animportant step forward.


lective defence mechanisms at the regional level.In this context, recent initiatives and proposals,

however modest they may be, constitute an im-portant step forward.

Notes

1 For instance, the report of the International Finan-cial Institutions Advisory Commission set up by theUnited States Congress (commonly referred to asthe “Meltzer Report”), recommended “that countriesavoid pegged or adjustable rates. The IMF shoulduse its policy consultations to recommend eitherfirmly fixed rates (currency board or dollarization)or fluctuating rates” (IFIC, 2000: 8).Similar viewshave been expressed by the former Treasury Secre-tary of the United States concerning the choice ofan appropriate exchange rate regime, “... which, foreconomies with access to international capital mar-kets, increasingly means a move away from themiddle ground of pegged but adjustable fixed ex-change rates towards the two corner regimes of ei-ther flexible exchange rates or a fixed exchange ratesupported, if necessary, by a commitment to giveup altogether an independent monetary policy”(Summers, 2000b: 8).

2 For an earlier account of this process, before therecent surge in capital flows to emerging markets,see TDR 1991 (Part Two, chap. III, sect. F); TDR1998 (Part One, chap. III, sect. B); and TDR 1999(Part Two, chap. VI).

3 For instance, the 1998 Brazilian programme withthe IMF had stipulated an orderly exit from the pegthrough gradual devaluations throughout 1999, aswell as emergency financing, but this did not pre-vent the crisis.

4 This inability of a country to borrow in its own cur-rency has been coined the “original sin hypothesis”(Hausmann, 1999; Eichengreen and Hausmann,1999). A corollary of this hypothesis is that “... thecountry’s aggregate net foreign exposure must beunhedged, by definition. To assume the ability tohedge is equivalent to assume that countries canborrow abroad in their own currencies but choosenot to do so, in spite of the fact that the market does

not appear to exist” (Eichengreen and Hausmann,1999: 25).

5 For an assessment of the experience in the 1980s,see UNCTAD secretariat (1987); Akyüz and Dell(1987); and also TDR 1990 (Part Two, chap. I). Forthe more recent experience, see previous TDR 1993(Part Two, chap. I); TDR 1994 (Part Two, chap. II);TDR 1995 (Part Two, chap. I); TDR 1996 (Part Two,chap. I); and TDR 1999 (chap. III).

6 For a debate on the relative costs and benefits ofhard pegs and floating rates, see Hausmann (1999)and Sachs and Larrain (1999).

7 The first major political initiative for a Europeanmonetary union was taken in 1969 with the adop-tion of the Werner Report, which proposed: for thefirst stage, a reduction of the fluctuation marginsbetween the currencies of the member States of theCommunity; for the second stage, the achievementof complete freedom of capital movements, with in-tegration of financial markets; and for the final stage,an irrevocable fixing of exchange rates between thecurrencies. In its first effort at creating a zone ofcurrency stability, the EEC attempted in 1971 to fixEuropean parities closer to each other than to thedollar, but with some flexibility (“the snake”). The“snake” rapidly died with the collapse of the dol-lar-based Bretton Woods system, but was reborn in1972 as the “snake in the tunnel”, a system whichnarrowed the fluctuation margins between the Com-munity currencies (the snake) in relation to thoseoperating between these currencies and the dollar(the tunnel). During the currency turmoil that ac-companied the 1973 oil crisis, this arrangementcould not function well, leading to various exits andfloating, until the establishment of the EMS in 1979.The United Kingdom was a member of the EMSbut did not participate in the ERM until 1990. Forthe history of European monetary integration and


the functioning of the EMS, see Bofinger andFlassbeck (2000).

8 For a useful survey of mechanisms for external pay-ments support in the EEC, see Edwards (1985: 326–346). As part of the establishment of the Economicand Monetary Union, the European Monetary Co-operation Fund – the body which administered short-term facilities under the heading of mutual externalfinancial support – was dissolved and its functionstaken over by the European Monetary Institute (EMI).

9 In addition, there was an obligation to take the meas-ures necessary for the proper functioning of sys-tems of taxation, prudential supervision, etc. Formore details, see Akyüz and Cornford (1995).

10 Such a regime is coined BBC (basket, band andcrawl) (Williamson, 2000).

11 This source also provides a detailed discussion ofother proposals for regional arrangements.

131Crisis Management and Burden Sharing

There is a growing body of opinion that ef-fective management of financial crises in emergingmarkets requires a judicious combination of ac-tion on three fronts: a domestic macroeconomicpolicy response, particularly through monetaryand fiscal measures and exchange rate adjustment;timely and adequate provision of international li-quidity with appropriate conditionality; and theinvolvement of the private sector, especially in-ternational creditors. With benefit of hindsight, itis now agreed that the international policy re-sponse to the Asian crisis was far from optimal,at least during the initial phase. An undue burdenwas placed on domestic policies; rather than re-storing confidence and stabilizing markets, hikesin interest rates and fiscal austerity served todeepen the recession and aggravate the financialproblems of private debtors. The international res-cue packages were designed not so much to protectcurrencies against speculative attacks or financeimports as to meet the demands of creditors andmaintain an open capital account. Rather than in-volving private creditors in the management andresolution of the crises, international intervention,coordinated by the IMF, in effect served to bailthem out.1

This form of intervention is increasingly con-sidered objectionable on grounds of moral hazardand equity. It is seen as preventing market disci-pline and encouraging imprudent lending, sinceprivate creditors are paid off with official moneyand not made to bear the consequences of the risksthey take. Even when the external debt is owedby the private sector, the burden ultimately fallson taxpayers in the debtor country, because gov-ernments are often obliged to serve as guarantors.At the same time, the funds required for suchinterventions have been getting ever larger and arenow reaching the limits of political acceptability.Thus, a major objective of private sector involve-ment in crisis resolution is to redress the balanceof burden sharing between official and privatecreditors as well as between debtors and creditors.

For these reasons, the issues of private sectorinvolvement and provision of official assistancein crisis management and resolution have beenhigh on the agenda in the debate on reform of theinternational financial architecture since the out-break of the East Asian crisis. However, despiteprolonged deliberations and a proliferation ofmeetings and forums, the international commu-

Chapter VI

CRISIS MANAGEMENT AND BURDEN SHARING

A. Introduction


nity has not been able to reach agreement on howto involve the private sector and how best to designofficial lending in financial crises. As acknowl-edged by the IMF, “While some success has beenachieved in securing concerted private sector in-volvement, it has become increasingly clear thatthe international community does not have at

its disposal the full range of tools that wouldbe needed to assure a reasonably orderly – andtimely – involvement of the private sector” (IMF,2000f: 10). This chapter seeks to address this prob-lem by defining the state of play, examining theissues that remain to be resolved and assessingvarious options proposed.

B. Private sector involvement and orderly debt workouts

Private sector involvement in financial cri-sis resolution refers to the continued or increasedexposure of international creditors to a debtorcountry facing serious difficulties in meeting itsexternal financial obligations, as well as to ar-rangements that alter the terms and conditions ofsuch exposure, including maturity rollovers anddebt write-offs.2 In this con-text, it is useful to make a dis-tinction between mechanismsdesigned to prevent panics andself-fulfilling debt runs, on theone hand, and those designedto share the burden of a crisisbetween debtors and creditors,on the other. To the extent thatprivate sector involvementwould help restrain asset grab-bing, it would also reduce theburden to be shared. For in-stance, debt standstills and rollovers can preventa liquidity crisis from translating into widespreadinsolvencies and defaults by helping to stabilizethe currency and interest rates. In this sense,private sector involvement in financial crises isnot always a zero sum game. It can also help re-solve conflict of interest among creditors them-selves by ensuring more equitable treatment.

Market protagonists often argue that foreigninvestors almost always pay their fair share of the

burden of financial crises in emerging markets.According to this view, international banks incurlosses as a result of arrears and bankruptcies, whileholders of international bonds suffer because thefinancial difficulties of the debtors affect the mar-ket value of bonds, and most private investorsmark their positions to market (Buchheit, 1999: 6).

Losses incurred in domesticbond and equity markets arealso cited as examples of bur-den sharing by private inves-tors.3

In assessing creditorlosses, it is important to bearin mind that, so long as thevalue of claims on the debtorremains unchanged, mark-to-market losses may involveonly a redistribution among

investors. On the other hand, net losses by credi-tors are often compensated by risk spreads onlending to emerging markets. For instance, on theeve of the Asian crisis, the total bank debt ofemerging markets was close to $800 billion.Applying a modest 300 basis points as the aver-age spread on these loans would yield a sum ofmore than $20 billion per annum in risk premium,compared to the estimated total mark-to-marketlosses4 of foreign banks of some $60 billion in-curred in emerging-market crises since 1997.

A major objective of privatesector involvement in crisisresolution is to redress thebalance of burden sharingbetween official and privatecreditors as well as betweendebtors and creditors.


Foreign investors are directly involved inburden sharing when their claims are denominatedin the currency of the debtor country and they rushto exit. This hurts them twice, by triggering sharpdrops both in asset prices and in the value of thedomestic currency. For this reason, countries thatborrow in their own currencies(or adopt a reserve currency astheir own) are expected to beless prone to currency and debtcrises since potential losseswould deter rapid exit andspeculative attacks.

However, the denomina-tion of external debt in the cur-rency of the debtor countrydoes not eliminate the so-called collective action prob-lem which underlines self-ful-filling debt runs and providesthe principal rationale for debtstandstills; even though creditors as a group are bet-ter off if they maintain their exposure, individualinvestors have an incentive to exit quickly for fearof others doing so before them. The consequent de-clines in domestic asset prices and in the value ofthe currency not only hurt creditors, but also haveserious repercussions for the debtor economy. Insome cases, there could be a run for the strongforeign-owned domestic banks as well, placing aparticular burden on locally-owned and smallerbanks and other financial institutions. It is for thesereasons that governments of debtor countries areoften compelled to take action to prevent a rapidexit of foreign investors from domestic capitalmarkets. Such actions may go beyond monetarytightening. In Mexico, for instance, market pres-sures in 1994 forced the Government to shiftfrom peso-denominated cetes to dollar-indexedtesebonos in the hope that removing the currencyrisks would persuade foreign creditors to stay.However, this did not prevent the eventual rushto exit, the collapse of the peso and hikes in inter-est rates. Thus, even when external debt is denomi-nated in domestic currency, arrangements to in-volve private creditors through standstills androllovers can play an important role in efforts toachieve greater financial stability.

As discussed in detail in TDR 1998, the ra-tionale and key principles for an orderly debt

workout can be found in domestic bankruptcy pro-cedures. Although chapter 11 of the United StatesBankruptcy Code is the most cited reference, othermajor industrial countries apply similar principles.These principles combine three key elements:(i) provisions for an automatic standstill on debt

servicing that prevents a “grabrace” for assets among thecreditors; (ii) maintaining thedebtor’s access to the workingcapital required for the con-tinuation of its operations (i.e.lending into arrears); and(iii) an arrangement for thereorganization of the debtor’sassets and liabilities, includingdebt rollover, extension of ex-isting loans, and debt write-offor conversion. The way theseelements are combined de-pends on the particularities ofeach case, but the aim is to

share the adjustment burden between debtor andcreditors and to assure an equitable distributionof the costs among creditors.

Under these procedures, standstills give thedebtor the “breathing space” required to formu-late a debt reorganization plan. While, in principle,agreement is sought from creditors for restructur-ing debt, the procedures also make provisions todiscourage holdouts by allowing for majority –rather than unanimous – approval of the creditorsfor the reorganization plan. The bankruptcy courtacts as a neutral umpire and facilitator, and whennecessary has the authority to impose a bindingsettlement on the competing claims of the credi-tors and debtor under so-called “cramdown”provisions.

Naturally, the application of national bank-ruptcy procedures to cross-border debt involves anumber of complex issues. However, fully-fledgedinternational bankruptcy procedures would not beneeded to ensure an orderly workout of interna-tional debt. The key element is internationallysanctioned mandatory standstills. Under certaincircumstances, it might be possible to reach agree-ment on voluntary standstills with creditors but,as recognized by the IMF, “… in the face of abroad-based outflow of capital, it may be diffi-cult to reach agreement with the relevant resident

While debtor countrieshave the option to imposeunilateral paymentsuspension, without astatutory basis such actioncan create considerableuncertainties, therebyreducing the likelihood oforderly debt workouts.


and nonresident investors ...” (IMF, 2000f: 10).On the other hand, while debtor countries havethe option to impose unilateral payment suspen-sion, without a statutory basis such action can cre-ate considerable uncertainties, thereby reducingthe likelihood of orderly debt workouts. Further-more, debtors could be deterred from applyingtemporary payment standstills for fear of litiga-tion and asset seizure by creditors, as well as of last-ing adverse effects on their reputation.

Standstills on sovereign debt involve suspen-sion of payments by governments themselves,while on private external debt they require animposition of temporary exchange controls whichrestrict payments abroad on specified transactions,including interest payments. Further restrictionsmay also be needed on capital transactions of resi-dents and non-residents (suchas acquisition of assets abroador repatriation of foreign capi-tal). Clearly, the extent towhich standstills would need tobe combined with such meas-ures depends on the degree ofrestrictiveness of the capitalaccount regime already inplace.

Since standstills and ex-change controls need to be im-posed and implemented rap-idly, the decision should restwith the country concerned,subject to a subsequent review by an internationalbody. According to one proposal, the decisionwould need to be sanctioned by the IMF. Clearly,for the debtor to enjoy insolvency protection, itwould be necessary for such a ruling to be legallyenforceable in national courts. This would requirea broad interpretation of Article VIII(2)(b) of theArticles of Agreement of the IMF, which couldbe provided either by the IMF Executive Boardor through an amendment of these Articles so asto cover debt standstills. In this context, Canadahas proposed an Emergency Standstill Clause tobe mandated by IMF members (Department of Fi-nance, Canada, 1998).

However, as argued in TDR 1998, the IMFBoard is not a neutral body and cannot, therefore,

be expected to act as an independent arbiter, be-cause countries affected by its decisions are alsoamong its shareholders. Moreover, since the Funditself is a creditor, and acts as the authority forimposing conditionality on the borrowing coun-tries, there can be conflicts of interest vis-à-visboth debtors and other creditors. An appropriateprocedure would thus be to establish an independ-ent panel for sanctioning such decisions. Such aprocedure would, in important respects, be simi-lar to GATT/WTO safeguard provisions that allowdeveloping countries to take emergency actionswhen faced with balance-of-payments difficulties(see box 6.1).

For private borrowers the restructuring ofdebts should, in principle, be left to national bank-ruptcy procedures. However, these remain highly

inadequate in most developingcountries (see chapter IV, sub-section B.6). Promoting an or-derly workout of private debt,therefore, crucially dependson establishing and develop-ing appropriate procedures.Ordinary procedures for han-dling individual bankruptciesmay be inappropriate and dif-ficult to apply under a morewidespread crisis, and theremay be a need to provide gen-eral protection to debtors whenbankruptcies are of a systemicnature. One proposal that has

been put forward is “… to provide quasi automaticprotection to debtors from debt increases due to adevaluation beyond a margin …” (Miller andStiglitz, 1999: 4). Clearly, the need for such pro-tection will depend on the extent to which stand-stills and exchange controls succeed in prevent-ing sharp declines in currencies. For sovereigndebtors, it is difficult to envisage formal bank-ruptcy procedures at the international level, butthey too could be given a certain degree of pro-tection against debt increases brought about bycurrency collapses. Beyond that, negotiations be-tween debtors and creditors appear to be the onlyfeasible solution. As discussed below, these maybe facilitated by the inclusion of various provi-sions in debt contracts, as well as by appropriateintervention of multilateral financial institutions.

While the internationalcommunity has increasinglycome to recognize thatmarket discipline will onlywork if creditors bear theconsequences of the risksthey take, it has beenunable to reach agreementon how to bring this about.


Box 6.1

GATT AND GATS BALANCE-OF-PAYMENTS PROVISIONSAND EXCHANGE RESTRICTIONS

The balance-of-payments provisions of Articles XII and XVIIIB of GATT 1994 al-low a Member to suspend its obligations under the Agreement, and to impose importrestrictions in order to forestall a serious decline in, or otherwise protect the level of,its foreign exchange reserves, or to ensure a level of reserves adequate for implemen-tation of its programme of economic development.1 The provisions of Article XVIIIB(part of Article XVIII dealing with governmental assistance to economic develop-ment) are directed particularly at payments difficulties arising mainly from a coun-try’s efforts to expand its internal market or from instability in its terms of trade.Permissible actions include quantitative restrictions as well as price-based measures.In applying such restrictions, the Member may select particular products or productgroups. The decision is taken unilaterally, with notification to the WTO Secretariatand subsequent consultations with other Members in the Committee on Balance-of-Payments Restrictions. Restrictions are imposed on a temporary basis, and are ex-pected to be lifted as conditions improve. However, the Member cannot be requiredto remove restrictions by altering its development policy.

Similar provisions are to be found in Article XII of the General Agreement on Tradein Services (GATS), which stipulates that, in the event of serious difficulties in thebalance of payments and in external finance, or a threat thereof, a Member may adoptor maintain restrictions on trade in services on which it has undertaken specific com-mitments, including on payments or transfers for transactions related to such com-mitments. Again, such restrictions are allowed to ensure, inter alia, the maintenanceof a level of financial reserves adequate for implementation of the Member’s pro-gramme of economic development or economic transition. The conditions andmodalities related to the application of such restrictions are similar to those in theGATT 1994 balance-of-payments provisions.

Clearly, these provisions are designed to avoid conditions in which countries areforced to sacrifice economic growth and development as a result of temporary diffi-culties originating in the current account of the balance of payments, particularlytrade deficits. Even though they may not be invoked directly for the restriction offoreign exchange transactions and the imposition of temporary standstills on debtpayments at times of severe payments difficulties arising from the rapid exit of capi-tal – and a consequent capital-account crisis – resort to such action in those circum-stances would be entirely in harmony with the provisions’ underlying rationale.

1 For more detailed discussion, see Jackson (1997, chap. 7); and Das (1999, chap. III.3).


Despite its potential benefits to both debtorsand creditors, private sector involvement in crisisresolution has proved to be one of the most con-tentious issues in the debate on reform of the in-ternational financial architecture. While the inter-national community has increasingly come to rec-ognize that market discipline will only work ifcreditors bear the consequences of the risks theytake, it has been unable to reach agreement on howto bring this about. According to one view, avoluntary and case-by-caseapproach would constitute themost effective way of involv-ing the private sector in crisisresolution. Another view isthat, for greater financial sta-bility and equitable burdensharing, a rules-based manda-tory approach is preferable.This divergence of views is notsimply between debtor andcreditor countries, but alsoamong the major creditorcountries.

The main argument in favour of a rules-basedsystem is that a case-by-case approach could leadto asymmetric treatment – not only betweendebtors and creditors, but also among differentcreditors. It would also leave considerable discre-tion to some major industrial powers, which havesignificant leverage in international financialinstitutions, to decide on the kind of interventionto be made in emerging-market crises. Privatemarket actors, as well as some major industrialcountries, are generally opposed to involuntarymechanisms on the grounds that they create moral

hazard for debtors, that they alter the balance ofnegotiating strength in favour of the latter, thatthey delay the restoration of market access, andthat they can be used to postpone the adjustmentsneeded.5

The recent debate within the IMF on privatesector involvement in crisis resolution appears tohave focused on three mechanisms. First, it isagreed that the Fund should try, where appropriate,

to act as a catalyst for lendingby other creditors to a coun-try facing payments difficul-ties. If this is inappropriate, orif it fails to bring in the pri-vate sector, the debtor coun-try should seek to reach anagreement with its creditors ona voluntary standstill. Finally,it is recognized that, as a lastresort, the debtor country mayfind it necessary to impose aunilateral standstill when vol-untary agreement is not feasi-

ble. All these measures should also be accompa-nied by appropriate monetary and fiscal tighten-ing and exchange rate adjustment. A report of themeeting of the IMF Executive Board concerningthe involvement of the private sector in the reso-lution of financial crises stated:

Directors agreed that, under the suggestedframework for involving the private sector,the Fund’s approach would need to be aflexible one, and the complex issues involvedwould require the exercise of considerablejudgement. … In cases where the member’sfinancing needs are relatively small or where,

C. Recent debate within the IMF

Current practices leave toomuch discretion to the Fundand its major shareholdersin decisions regarding thetiming and extent of theofficial financing it shouldprovide, and under whatconditions.


despite large financing needs, the memberhas good prospects of gaining market accessin the near future, the combination of strongadjustment policies and Fund support shouldbe expected to catalyze private sector in-volvement. In other cases, however, whenan early restoration of market access onterms consistent with medium-term exter-nal sustainability is judged to be unrealistic,or where the debt burden is unsustainable,more concerted support from private credi-tors may be necessary, possibly includingdebt restructuring …

Directors noted that the term “standstill”covers a range of techniques for reducingnet payment of debt service or net outflowsof capital after a country has lost spontane-ous access to international capital markets.These range from voluntary arrangementswith creditors limiting net outflows of capi-tal, to various concerted means of achievingthis objective.

Directors underscored that the approach tocrisis resolution must not undermine theobligation of countries to meet their debt infull and on time. Nevertheless, they notedthat, in extreme circumstances, if it is notfeasible to reach agreement on a voluntarystandstill, members may find it necessary,as a last resort, to impose one unilaterally.Directors noted that … there could be a riskthat this action would trigger capital out-flows. They recognized that if a tighteningof financial policies and appropriate ex-change rate flexibility were not successfulin stanching such outflows, a member wouldneed to consider whether it might be neces-sary to resort to the introduction of morecomprehensive exchange or capital controls.(IMF, 2000h)6

Clearly, there still remains the possibility oflarge-scale bailout operations. Some countriesapparently attempted to exclude this possibility,but could not secure consensus:

A number of Directors favoured linking astrong presumption of a requirement forconcerted private sector involvement tothe level of the member’s access to Fundresources. These Directors noted that arules-based approach would give more

predictability to the suggested frameworkfor private sector involvement, while limit-ing the risk that large-scale financing couldbe used to allow the private sector to exit.Many other Directors, however, stressed thatthe introduction of a threshold level ofaccess to Fund resources, above which con-certed private sector involvement would beautomatically required, could in some caseshinder the resumption of market access fora member with good prospects for the suc-cessful use of the catalytic approach tosecuring private sector involvement.

Nor has there been agreement over empow-ering the IMF to impose stay on creditor litigationin order to provide statutory protection to debtorsthat impose temporary standstills:

Most Directors considered that the appro-priate mechanism for signalling the Fund’sacceptance of a standstill imposed by amember was through a decision for the Fundto lend into arrears to private creditors …Some Directors favored an amendment toArticle VIII, section 2(b), that would allowthe Fund to provide a member with someprotection against the risk of litigationthrough a temporary stay on creditor litiga-tion. Other Directors did not favor such anapproach, and noted that in recent casesmembers’ ability to reach cooperative agree-ments with private creditors had not beenhampered by litigation.

Considerable flexibility is undoubtedly neededin handling financial crises since their form andseverity can vary from country to country. How-ever, current practices leave too much discretionto the Fund and its major shareholders in decisionsregarding the timing and extent of the officialfinancing it should provide, and under what con-ditions; how much private sector involvement itshould require; and under what circumstances itshould give support to unilateral payment stand-stills and capital controls. The suggested frame-work generally fails to meet the main concerns ofdebtor countries regarding burden sharing in cri-sis resolution and the modalities of IMF supportand conditionality. Nor does it provide clear guide-lines to influence the expectations and behavioursof debtors and creditors with the aim of securinggreater stability.


The above discussion suggests that there isnow a greater emphasis on private sector in-volvement when designing official assistance tocountries facing financial difficulties. The ele-ments of this strategy include the use of officialmoney as a catalyst for private financing, lendinginto arrears to precipitate agreement between debt-ors and creditors, and making official assistanceconditional on prior private sector participation.Some of these policies were, in fact, used for theresolution of the debt crisis in the 1980s, althoughtheir objectives were not always fully met. Forinstance, under the so-called Baker Plan, officiallending to highly-indebted developing countriessought to play a catalytic role, but faced stiff op-position from commercial banks, which refusedto lend to these countries. The practice of IMFlending to debtors that are in arrears on paymentsowed to private creditors dates back to the BradyPlan of 1989, when commercial banks were nolonger willing to cooperate in restructuring thirdworld debt as they had made sufficient provisionsand reduced their exposure to developing countryborrowers. A decision by the IMF Board in Sep-tember 1998 formally acknowledged lending intoarrears as part of the Fund’s lending policy andextended this practice to bonds and non-bank cred-its in the expectation that it would help countrieswith Fund-approved adjustment programmes torestructure their private debt.7

The current emphasis on official assistancebeing made conditional on private sector partici-pation includes a commitment not to lend or grantofficial debt relief unless private markets similarlyroll over their maturing claims, lend new moneyor restructure their claims. This strategy, which

has come to be known as “comparability of treat-ment”, aims not only at preventing moral hazardas it pertains to private creditors, but also at en-suring an acceptable form of burden sharingbetween the private and official creditors. Its un-derlying principle is that public assistance shouldnot be made available unless debtors get somerelief from private creditors, and no class of pri-vate creditors should be exempt from burdensharing.8 In 1999, Paris Club creditors specificallyadvised Pakistan to seek comparable treatmentfrom its private bondholders by rescheduling itseurobond obligations. However, this policy doesnot seem to have been implemented in the caseof recent official assistance to Ecuador, when theIMF did not insist that the country reach an agree-ment on restructuring with the holders of its Bradybonds as a precondition for official assistance (seebox 6.2; and Eichengreen and Ruhl, 2000: 19).

Certainly, the emphasis on burden sharingand comparable treatment between private andofficial creditors constitutes a major advance overthe debt strategies adopted in the 1980s and in themore recent emerging-market crises. During theseepisodes, official intervention was designed pri-marily to keep sovereign debtors current on debtservicing to private creditors and the seniorityaccorded to multilateral debt went unchallenged.However, the emphasis on burden sharing amongcreditors does not necessarily lead to improvedoutcomes regarding the more important questionof burden sharing between debtors and creditors.

In this respect, a key issue is whether a strat-egy that makes official assistance conditional onprivate sector participation could succeed in pro-

D. Official assistance, moral hazard and burden sharing


Box 6.2

RECENT BOND RESTRUCTURING AGREEMENTS

A number of recent sovereign bond restructuring agreements have been widely hailed by the inter-national community for their success “... in puncturing unsustainable expectations of some inves-tors that international sovereign bonds were, in effect, immune from restructuring ...” (IMF,2000f: 10). However, they also show that, under current institutional arrangements, there are noestablished mechanisms for an orderly restructuring of sovereign bonds, and that the process canbe complex and tedious.1 Success in bringing bondholders to the negotiating table does not dependon the presence of CACs in bond documents alone. A credible threat of default could be just aseffective. However, even then, the debtors are not guaranteed to receive significant debt relief,particularly on a mark-to-market basis.

Pakistan restructured its international bonds at the end of 1999 without invoking the CACs presentin its bonds, preferring a voluntary offer to exchange its outstanding eurobonds for a new six-yearinstrument, which was accepted by a majority of the bondholders. Communication problems werenot serious because the bonds were held by only a few Pakistani investors. It is believed that thepresence of CACs and a trustee, as well as the request of the Paris Club to extend “comparability oftreatment” to eurobonds, along with a credible threat of default, played an important role in dis-couraging holdouts.2 However, the terms of restructuring were quite favourable to bondholderscompared to the prevailing market price, and the new bonds offered were more liquid. Accordingto the IMF, there was a “haircut” for the creditors compared to the relative listing price but not tothe relative market value, and although the initial impact of the restructuring on the debt profile ofthe country was somewhat positive, “by 2001 market estimates suggest that debt-service paymentswill be back to levels before restructuring and will be higher for the remaining life of the exchangebond” (IMF, 2000g: 137 and table 5.2).

By contrast, Ukraine made use of the CACs present in four of its outstanding bonds in a restruc-turing concluded in April 2000. Unlike Pakistan, the bonds were spread widely among retail hold-ers, particularly in Germany, but the country managed to obtain the agreement of more than 95 percent of the holders on the outstanding value of debt. As in Pakistan, however, this involved onlythe extension of principal maturities rather than relief, since reorganization was undertaken on amark-to-market basis. Indeed, there was a net gain for creditors relative to market value (IMF,2000g, table 5.2).

From mid-1999 Ecuador started having serious difficulties in making interest payments on itsBrady bonds, ending up in a default in the second half of the year. As rolling over maturities wouldnot have provided a solution, the country sought a large amount of debt reduction by offering anexchange for global bonds issued at market rates, but with a 20-year maturity period. This wasrejected by the bondholders, who furthermore, voted for acceleration. After a number of failedattempts, Ecuador invited eight of the larger institutional holders of its bonds to join a Consulta-tive Group, with the aim of providing a formal mechanism of communication with bondholdersrather than negotiating terms for an exchange offer. In mid-August, bondholders accepted Ecua-dor’s offer to exchange defaulted Brady bonds for 30-year global bonds at a 40 per cent reductionin principal, while the market discount was over 60 per cent. This resulted in a net gain for thecreditors relative to market value.3

1 On these restructuring exercises, see De la Cruz (2000); Eichengreen and Ruhl (2000); Buchheit (1999);and IMF (2000g, box 5.3).

2 For a different view on the impact of the Paris Club’s request, see Eichengreen and Ruhl (2000: 26–28).3 For an assessment of the Ecuadorian restructuring, see Acosta (2000).


moting orderly debt workouts with private credi-tors. The rationale for this strategy is that, if theFund were to stand aside and refuse to lend to acountry under financial stress unless the marketsrolled over their claims first, private creditorswould be confronted with the prospect of default,which would encourage themto negotiate and reach agree-ment with the debtor. Themain weakness of this strategyis that, if the default is not verycostly, creditors will have lit-tle incentive for restructuringtheir claims. On the otherhand, if it is costly, the IMFwill not be able to stand by andlet it happen, since the threatto international financial sta-bility, as well as to the countryconcerned, would be serious.The insistence on IMF non-intervention would beno more credible than an announcement by a gov-ernment that it will not intervene to save citizenswho have built houses in a flood plain.9 This di-lemma provides a strong case for explicit rulesprohibiting the building of houses in flood plainsor a “grab race” for assets.10

Thus it appears that a credible strategy forinvolving the private sector in crisis resolutionshould combine temporary standstills with strictlimits on access to Fund resources. Indeed, such astrategy has received increased support in recentyears.11 According to one view, access could belimited by charging penalty rates. However, sincesuch price-based measures are unlikely to succeedin checking distress borrowing under crisis con-ditions, quantitative limits will be needed. A recentreport by the United States Council on ForeignRelations (CFR) on reform of the international fi-nancial architecture argued that the IMF shouldadhere consistently to normal access limits of100 per cent of quota annually and 300 per centon a cumulative basis, and that countries shouldbe able to resort to unilateral standstills when suchfinancing proves inadequate to stabilize marketsand their balance of payments. The amounts com-mitted in recent interventions in emerging-marketcrises, beginning with the one in Mexico in 1995,far exceeded these limits, being in the range of500 per cent to 1,900 per cent of quota.

However, in setting such access limits, itshould be recognized that IMF quotas have laggedbehind growth of global output, trade and finan-cial flows, and their current levels may not pro-vide appropriate yardsticks to evaluate the size ofIMF packages. According to one estimate, adjust-

ing quotas for the growth inworld output and trade since1945 would require them to beraised by three and nine times,respectively (Fischer, 1999).In an earlier proposal – madein an IMF paper on the eve ofthe Mexican crisis – to createa short-term financing facilityfor intervention in financialcrises, 300 per cent of quota wasconsidered a possible upperlimit (see TDR 1998, chap. IV,sect. B.4). Such amounts ap-

pear to be more realistic than current normal ac-cess limits.

Fund resources are not the only source ofrescue packages, and in many cases bailouts relyeven more on the money provided by some majorcreditor countries. This practice has often in-creased the scope for these countries to pursuetheir own national interests in the design of res-cue packages, including the conditionalitiesattached to lending. It is highly probable that ma-jor creditor countries will continue to act in thismanner whenever and wherever they see their in-terests involved, and some debtor countries mayeven prefer to strike bilateral deals with themrather than going through multilateral channels.However, limits on access to Fund resourcesshould be observed independently of bilaterallending under crisis. Furthermore, it is desirableto keep such ad hoc bilateral arrangements sepa-rate from multilateral lending in order to reducethe scope for undue influence over Fund policiesby some of its major shareholders.

A key question is whether such access limitsshould be exceeded under certain circumstances.For instance, while arguing for strict limits, theCFR report suggested, “In the unusual case inwhich there appears to be a systemic crisis (thatis, a multicountry crisis where failure to intervenethreatens the performance of the world economyand where there is widespread failure in the abil-

A credible strategy forinvolving the private sectorin crisis resolution shouldcombine temporarystandstills with strict limitson access to Fundresources.


ity of private capital markets to distinguish cred-itworthy from less creditworthy borrowers), theIMF would return to its ‘systemic’ backup facili-ties …” (CFRTF, 1999: 63). It proposed the crea-tion of a facility to help prevent contagion, to befunded by a one-off allocation of special drawingrights (SDRs),12 which would replace the existingIMF facilities for crisis lending (see box 6.3).

While the concerns underlying different lend-ing policies for systemic and non-systemic crisesmay be justified, in practice exceptions to normallending limits could leave considerable room forlarge-scale bailout operations and excessive IMFdiscretion. One possible implication is that coun-tries not considered systemically important couldface strict limits in access to Fund resources, but

Box 6.3

RECENT INITIATIVES IN IMF CRISIS LENDING

The IMF has recently taken steps to strengthen its capacity to provide financing in crises, thoughthis capacity still falls short of that of a genuine international lender of last resort.1 The Supple-mental Reserve Facility (SRF), approved by the IMF’s Executive Board in response to the deepen-ing of the East Asian crisis in December 1997, was designed to provide financing without limits tocountries experiencing exceptional payments difficulties, but under a highly conditional stand-byor Extended Arrangement (IMF, 1998b: 7). However, the SRF depends on the existing resources ofthe Fund which, recent experience suggests, are likely to be inadequate on their own to meet thecosts of large interventions.

The Contingency Credit Line (CCL), created in Spring 1999, is intended to provide a precaution-ary line of defence in the form of short-term financing, which would be available to meet balance-of-payments problems arising from international financial contagion (IMF, 1999). Thus, unlike theSRF, which is available to countries in crisis, the CCL is a preventive measure. Countries can pre-qualify for the CCL if they comply with conditions related to macroeconomic and external finan-cial indicators and with international standards in areas such as transparency, banking supervisionand the quality of banks’ relations and financing arrangements with the private sector. The pres-sures on the capital account and international reserves of a qualifying country must result from asudden loss of confidence amongst investors triggered largely by external factors. Moreover, al-though no limits on the scale of available funds are specified, like the SRF, the CCL depends on theexisting resources of the Fund. Originally, it was expected that the precautionary nature of theCCL would restrict the level of actual drawings. However, in the event, no country has applied forthis facility. It is suggested that, under the initial terms, countries had no incentive to pre-qualifi-cation because fees and interest charges on the CCL were the same as under the SRF. In addition,access was not automatic, but subject to the Board’s assessment of policies and risks of contagioneffects. The IMF Board took steps in September 2000 to lower charges as well as to allow someautomatic access with a view to enhancing the potential use of the CCL (IMF, 2000j), but thereappear to be more serious design problems. In particular, countries seem to avoid recourse to it forfear that it will have the effect of a tocsin in international financial markets, thus stifling access tocredit.2

1 For a discussion of these facilities, see IMF (2000i). For a discussion of the issues involved in establish-ing an international lender of last resort, see TDR 1998 (chap. IV, sect. B.4), and Akyüz and Cornford(1999).

2 For an earlier assessment along these lines, see Akyüz and Cornford (1999: 36). For a more recentassessment, see Goldstein (2000: 12–13).


would have the option of imposing unilateralstandstills. However, for larger emerging marketsbailouts would still be preferred to standstills.Recent events involving defaults by Pakistan andEcuador (see box 6.2), but rescue operations forArgentina and Turkey (see chapter II) bear this

out. In the latter cases, difficulties experiencedwere largely due to the currency regimes pursuedrather than to financial contagion from abroad.However, there is wide concern that if these cri-ses had been allowed to deepen, they could havespread to other emerging markets.

E. Voluntary and contractual arrangements

As noted above, considerable emphasis isnow being placed on voluntary mechanisms forthe involvement of the private sector in crisis man-agement and resolution. However, certain featuresof the external debt of developing countries renderit extremely difficult to rely on such mechanisms,particularly for securing rapid debt standstills androllovers. These include a wider dispersion ofcreditors and debtors and the existence of a largervariety of debt contracts associated with the grow-ing spread and integration of international capitalmarkets, as well as innovations in sourcing for-eign capital. As a result, the scope of some of thevoluntary mechanisms used in the past has greatlydiminished.

Perhaps the most important development,often cited in this context, is the shift from syndi-cated bank loans to bonds in sovereign borrowing,since, for reasons examined below, bond restruc-turing is inherently more difficult. Sovereign bondissues were a common practice in the interwaryears when emerging markets had relatively easyaccess to bond markets. During the global finan-cial turmoil of the late 1920s and early 1930s,many of these bond issues ended up in defaults.There was little recourse to bond financing byemerging-market governments prior to the 1990s.The share of bonds in the public and publicly guar-anteed long-term debt of developing countries

stood at some 6.5 per cent in 1980, but rose rap-idly over the past two decades, reaching about21 per cent in 1990 and almost 50 per cent in 1999(World Bank, 2000). This ratio is lower for pri-vate, non-guaranteed debt, but the increase in theshare of bonds in private external debt is equallyimpressive – from about 1 per cent in 1990 to some24 per cent in 1999. According to the Institute ofInternational Finance (IIF), from 1992 to 1998,of a total of about $1,400 billion net capital flowsto 29 major emerging markets, 23 per cent camefrom commercial banks and 27 per cent from otherprivate creditors, mainly through bonds (IIF, 1999,table 1).

A second important development is that in-ternational lending to emerging markets has beenincreasingly to private sector borrowers. The shareof public and publicly guaranteed debt in thetotal long-term debt of developing countries ex-ceeded 75 per cent in the 1980s, but stood at lessthan 60 per cent in 1999. The increased impor-tance of private sector borrowing has meant a rapidincrease in the dispersion of debtors. While animportant part of private borrowing consists ofinterbank loans, direct lending to corporations isalso important in some emerging markets. In In-donesia, for example, such borrowing accountedfor more than three quarters of the total privatedebt. Furthermore, in developing countries, an


increasing proportion of the private sector’s ex-ternal bank debt is in the form of bilateral ratherthan syndicated lending, implying also a greaterdispersion of creditors. The creditor base is furtherbroadened as a result of repackaging arrangementsand credit derivatives, whereby economic inter-est in the original loan is passed on to third parties(Yianni, 1999: 81–84).

Various developments regarding emerging-market debt have also increased the scope for rapidexit and creditor runs, thereby reducing the roomfor cooperative solutions. Perhaps the most im-portant of these is the shift in bank lending towardsmore short-term loans. In the mid-1980s, bankloans with a maturity of less than one year ac-counted for around 43 per cent of total bank loans,but they increased to almost 60 per cent on theeve of the Asian crisis, and dropped to about50 per cent thereafter. Similarly, the widespreaduse of acceleration and cross-default clauses andput options in credit contracts has increased thescope for dissident holdouts, making it difficultfor debtors and creditors to reach rapid agreementon voluntary standstills and workouts.13

A number of proposals have been made fordesigning mechanisms to facilitate voluntary in-volvement of the private sector in crisis resolution.In discussing these mechanisms, it is useful tomake a distinction between bond covenants andother contractual and cooperative arrangementsdesigned to “bind in” and “bail in” the privatesector.

1. Bond restructuring and collectiveaction clauses

As already noted, the notion that sovereignbonds as well as bank loans may need to be re-structured has only recently been accepted by theinternational community (though not necessarilyby all segments of financial markets). The emerg-ing-market sovereign debtors that had issuedbonds in the 1970s and 1980s generally remainedcurrent on such obligations during the debt crisisof the 1980s while rescheduling and restructuringtheir commercial bank debt – a factor that appearsto have played an important role in the rapid ex-

pansion of bond financing in the 1990s relative tobank lending. As a result of this rapid increase,together with the increased frequency of virulentfinancial crises, bond restructuring has gainedin importance, particularly for sovereign borrow-ers.

However, there are serious difficulties inbond restructuring compared to rescheduling andrestructuring of syndicated credits. First of all,there are collective representation and collectiveaction problems, which are more acute with bondsthan with loan contracts. These arise from com-munication difficulties between the bond issuerand holders; in general bondholders are anony-mous and more diverse and include a variety ofinvestors, both individual and institutional. Thecommunication problem is further aggravated bytrading in secondary markets. Moreover, there arelegal impediments to the establishment of com-munication mechanisms between issuers andholders, as well as to dealing with non-participat-ing holders, that vary according to the legislationgoverning bonds. Again, as legislation for bondcontracts varies, it becomes difficult to applyuniform procedures in restructuring. Current ar-rangements also encourage holdouts and litigationby bondholders since, unlike the practice duringthe interwar years, sovereign issuers are often re-quired to include a waiver of sovereign immunity.Thus, sovereign debtors do not enjoy the protec-tion accorded to private debtors under domesticbankruptcy and insolvency procedures that oftenoverrule holdouts and eliminate free riders.

Quite independently of the contractual andlegal provisions governing a bond, a sovereignissuer facing serious financial difficulties alwayshas the option of making an offer to exchange itsexisting bonds with new instruments containingnew terms of payment. However, the problems ofcommunication and holdouts render such ex-change offers difficult to implement effectively.Thus, since the Mexican crisis, emerging-marketborrowers have been increasingly urged to includeso-called collective action clauses (CACs) in bondcontracts in order to improve communication withbondholders and facilitate bond restructuring.14

Such clauses appear to be particularly desirablefor sovereign borrowers, who do not benefit fromnational bankruptcy codes. There are basicallythree types of CACs:


• collective representation clauses, designed toestablish a representative forum (e.g. a trus-tee) for coordinating negotiations betweenthe issuer and bondholders;

• majority action clauses, designed to empowera qualified majority (often 75 per cent) ofbondholders to agree to a change in paymentterms in a manner which is binding on allbondholders, thereby preventing holdouts;and

• sharing clauses, designed to ensure that allpayments by the debtor are shared amongbondholders on a pro-rated basis, and to pre-vent maverick litigation.

It should be noted that the inclusion of CACsin bond contracts, where allowed by law, is op-tional – not mandatory – and often depends onmarket convention. Issuers generally adopt thedocumentation practices prevailing in the juris-diction of the governing law. In general, collectiverepresentation clauses are not contained in bondsgoverned either by English law or New York law.Majority action clauses are routinely included inbond contracts governed by English law, but notin those issued under New York law, even thoughthe latter does not precludethem from sovereign issues.Similarly, bonds governed byGerman and Japanese laws donot generally contain majorityaction clauses. In these cases,any change to the terms ofpayment requires a unanimousdecision by the bondholders.This is also true for Bradybonds, even when governed byEnglish law. It appears that theinclusion of a unanimity rulewas a major reason for theBrady process to be imple-mented through loan-for-bondexchanges rather than throughamendments to the existing loancontracts (Buchheit, 1999: 9).Sharing clauses are routinely included in syndi-cated bank loans, but are uncommon in publiclyissued bonds since they are often viewed by mar-kets as a threat to the legal right of creditors toenforce their claims.15 The absence of sharing

clauses, together with the waiver of sovereignimmunity, leaves considerable room for bondhold-ers to hold out against restructuring and to enterinto a “grab race” for assets through litigation.

According to available data, about one thirdof total bonds issued by emerging markets duringthe 1990s were governed by English law; the shareof bonds issued under New York law was lower,but still exceeded a quarter, followed by those is-sued under German law (just under one fifth) andJapanese law (around 13 per cent). It appears thatAsian, and particularly Latin American, emerg-ing markets have made greater use of New Yorklaw than English law in their issues. Japanese lawis seldom used in Latin American issues but gov-erns about a quarter of Asian issues, while theopposite is true concerning the use of German law.Between 1995 and 2000, there was an increase inthe proportion of bonds governed by New Yorklaw, but it is not clear if this is linked to the in-creased frequency of financial crises in emergingmarkets (Dixon and Wall, 2000: 145–146; Eichen-green and Mody, 2000a, table 1).

It is estimated that about half of all outstand-ing international bond issues – including thoseissued by industrial countries – do not include

CACs, and this proportion iseven greater for emerging-market bonds. A major con-cern of emerging markets isthat the inclusion of CACswould curtail their access tomarkets and raise the cost ofborrowing because it wouldsignal a greater likelihood ofdefault. They thus insist thatsuch clauses be introducedfirst in sovereign bonds of in-dustrial countries. Some in-dustrial countries, such asCanada and the United King-dom, have recently decided toinclude or extend CACs intheir international bond andnote issues in order to encour-

age a wider use of such clauses, particularly byemerging markets. International private sectorgroups find majority voting acceptable, subject toa threshold in the order of 90–95 per cent, but theyprefer voluntary exchange offers, and are opposed

A major concern ofemerging markets is thatthe inclusion of collectiveaction clauses would curtailtheir access to markets andraise the cost of borrowingbecause it would signal agreater likelihood of default,but the empirical evidenceon the impact of suchclauses on the cost ofinternational bond financingis inconclusive.


to making CACs mandatory in bond contracts(IMF, 2000g: table 5.2; Dixon and Wall, 2000: ta-ble 2).

The empirical evidence on the impact ofCACs on the cost of international bond financingis inconclusive (BIS, 1999; Eichengreen andMody, 2000b; Dixon and Wall, 2000). Indeed,CACs can have two opposite effects. On the onehand, their inclusion can raise the default prob-ability in the eyes of investors since they maycreate moral hazard for thedebtor, leading to a higher riskpremium. On the other hand,in the event of a default, suchclauses help recover the claimsof investors by facilitatingbond restructuring. The neteffect depends on how CACsaffect the perceived defaultprobability and the expectedrecovery rate. For countrieswith high credit ratings, the latter effect coulddominate, so that the inclusion of CACs may, infact, lower the cost of bond financing. For lower-rated bonds, however, such clauses may well leadto sharp increases in the perceived risk of default,thereby raising the spread on new issues.

It is not clear if the introduction of CACs inbond contracts could make a major impact on debtrestructuring, since experience in this respect ishighly limited.16 In any case, even if such clauseswere rapidly introduced by emerging-market bor-rowers in their new bond issues, the initial impactwould be limited because of the existence of alarge stock of outstanding bonds without CACs.On the other hand, CACs have been rarely usedby emerging markets for bond restructuring evenwhen they are present in bond contracts, partlybecause of the fear that bondholders’ meetingscould be used to mobilize opposition against at-tempts to restructure bonds and to take a decisionfor acceleration (which typically requires the con-sent of 25 per cent of bondholders). Clearly, suchrisks can be serious, since the ultimate decisionon restructuring lies with bondholders, and thesovereign debtor does not have the means of ob-taining court approval for its restructuring plan,as provided, for instance, under the “cramdown”provisions of the United States Bankruptcy Codefor corporate borrowers.

In assessing the potential role of CACs ininvolving the private sector in crisis resolution, itis important to distinguish between standstills andfinancial restructuring. The existing practice re-garding bond issues leaves little scope for securinga rapid standstill on a voluntary basis.17 Such astandstill requires representational bodies, such astrustees or bondholder committees, as well as pro-hibition of litigation by individual bondholdersand/or sharing clauses. As already noted, there isstrong resistance by private investors to the in-

clusion of such clauses acrossalmost all jurisdictions, andthey are not likely to be intro-duced on a voluntary basis.Majority action clauses alonecannot secure rapid voluntarystandstill and “cramdown”on dissident bondholders, be-cause invoking such clauses isa tedious process and leavesample time and opportunities

for rogue bondholders to impose a financial stran-glehold over the debtor.

Private investors often point out that themajor financial crises in emerging markets werenot precipitated by a rapid exit of holders of sov-ereign bonds through litigation and a “grab race”for assets, but by short-term hot money (Buchheit,1999: 7). This is certainly true for East Asia, wheresovereign bond debt was generally negligible.However, with the rapid growth of the bond mar-ket, granting bondholders unmitigated power oflitigation and asset attachment is potentially a se-rious source of instability. As already discussed,the current emphasis in official lending on pri-vate sector participation is unlikely to generateadequate incentives for voluntary standstill androllover of private debt at times of crisis.

The consequences of unilateral suspension ofpayments on bonds could be more serious thandefaults on bank debt because the effect would beimmediately transmitted to secondary markets. Asharp increase in the risk premium and a declinein bond prices would then create considerableopportunities for profit-making by litigious inves-tors (the so called “vultures”), who could acquiredistressed debt at substantial discounts and pur-sue a “grab race” for assets.18 On the other hand,as some recent bond restructuring exercises show,

The existing practiceregarding bond issuesleaves little scope forsecuring a rapid standstillon a voluntary basis.


even when unilateral defaults lead to an agree-ment on restructuring, the process tends to bedisorderly and does not always guarantee signifi-cant relief for the debtor (see box 6.2).

Thus a possible solution would be to combineinternationally sanctioned mandatory standstillswith majority action clauses in order to prevent a“grab race” for assets and facilitate voluntaryrestructuring. One proposal (Buiter and Silbert,1999) favours a contractually-based approach tostandstill, which would require all internationalloan agreements to include an automatic univer-sal debt rollover option with a penalty (UDROP).However, such a clause is unlikely to be intro-duced voluntarily and would need an internationalmandate. Another proposal is to empower theFund to impose or sanction standstills on bond-holders at the outbreak of a crisis (see, for exam-ple, Miller and Zhang, 1998). This could be com-bined with IMF lending into arrears, when needed,in order to alleviate the liquidity squeeze on thedebtor country and encourage a rapid restructur-ing. Debt restructuring should be left to a volun-tary agreement between the bondholders and theissuer, subject to provisions in the bond contracts.It is neither feasible nor desirable to empower theIMF or any other international authority to im-pose restructuring of sovereign debt, such as theone practised under the “cram-down” provisions of chapter 11of the United States Bank-ruptcy Code. Nevertheless, theFund could still exert consid-erable influence on the pro-cess through its policy of con-ditionality on lending.

It has been argued thatproposals such as CACs andstanding committees “… areappropriate if it is one’s judge-ment that most countries thatexperience crises have prob-lems with fundamentals that require debts to berestructured in the absence of a bailout. ...UDROPs and internationally sanctioned standstillsare appropriate if one instead believes that mostcrises are caused by creditor panic, and that allthat is required to restore order to financial mar-kets is a cooling-off period” (Eichengreen andRuhl, 2000: 4, footnote 4). However, the consid-

erations above suggest that both instruments areneeded in the arsenal of measures since resolu-tion of most crises requires both a cooling-offperiod and debt-restructuring. Even when the un-derlying fundamentals are responsible for a crisis,debtors need breathing space, as markets have atendency to overreact, and this leads to overshoot-ing of asset prices and exchange rates, therebyaggravating the financial difficulties of the debt-ors. Under such circumstances, standstills wouldallow time to design and implement cooperativesolutions to debt crises.

2. Restructuring bank loans

For the reasons already discussed, it is gen-erally believed that debt workouts are easier forinternational bank loans than for sovereign bonds,as they allow greater scope for voluntary and con-certed mechanisms. Furthermore, the experiencein the 1980s with restructuring of syndicatedcredits, and the more recent negotiations androllover of bank loans in the Republic of Koreaand Brazil, are often cited as successful examplesof debt workouts with banks.19 However, a closerlook at these experiences shows that there are con-

siderable weaknesses in theprocedures followed, and theoutcomes reached appear tobail out – rather than bail in –the private sector.

A main factor, whichfacilitated negotiations withcommercial banks in the1980s, was the existence ofadvisory or steering commit-tees consisting of representa-tives of banks selected mainlyon the basis of their exposureto the debtor country con-

cerned. Clearly, this helped solve the representa-tion problem by providing a forum for nego-tiations. Furthermore, the presence of sharingclauses in syndicated loan contracts, together withsovereign immunity, deterred litigation againstdebtor countries. However, agreement required theunanimous consent of committee members, whowere also expected to strike a deal that would be

A possible solutionwould be to combineinternationally sanctionedmandatory standstills withmajority action clauses inorder to prevent a “grabrace” for assets andfacilitate voluntaryrestructuring.


acceptable to non-participating banks. This, in ef-fect, allowed considerable room for holdouts byindividual banks, in much the same way as bondcontracts without majority action clauses. Suchholdouts resulted in protracted negotiations, lead-ing to frictions not only between debtors and credi-tors but also among creditors themselves. As notedby an observer of sovereign debt reschedulings inthe 1980s: “From the borrower’s perspective, theunanimous consent method translated into alwaysbeing negotiated down to the minimum commondenominator, one acceptable to all members of thecommittee based on consultation with their respec-tive constituencies. Namely, one bank had theability to prevent an entire package from beingadopted if it disagreed with any one of its fea-tures” (De la Cruz, 2000: 12).

The primary strategy of these negotiationswas to avoid default and to ensure that the debtorhad enough liquidity to stay current (i.e. to con-tinue servicing its debt). The money needed wasprovided by the creditor banks as part of the re-scheduling process as well as through officiallending. In this way banks could keep these as-sets in their balance sheets without violatingregulatory norms regarding credit performance.Maturities were rolled over as they became due,but concessional interest rates and debt cancella-tion were not among the guiding principles ofcommercial debt workouts.

Thus, as described in TDR 1988, the processinvolved “concerted lending”, whereby each bankrescheduled its loans and contributed new moneyin proportion to its existing exposure, the aggre-gate amount being the minimum considered nec-essary to avoid arrears. The IMF also made itsprovision of resources to debtor countries – to keepthem current on interest payments to commercialbanks – contingent upon the banks’ making thecontributions required of them. Thus, official in-tervention amounted to using public money to paycreditor banks even though it was designed to bindthe banks in. Developing countries saw their debtgrowing, not only to commercial banks, but alsoto the official creditors, as they borrowed to re-main current on their interest payments (TDR1988, Part One, chap. V).

The negotiated settlements also resulted inthe socialization of private debt in developing

countries when governments were forced to as-sume loan losses, thereby, in effect shifting theburden to the tax payers. For example, in the caseof Chile, it was noted that “private debts have beenincluded in debt rescheduling being negotiatedbetween the Chilean State and the foreign bankadvisory committee for Chile. Apparently theChilean Government caved in under pressure fromthe bank advisory committee … To make theirviewpoint absolutely clear, foreign banks appar-ently tightened up their granting of very short-termcommercial credits to Chile during the first quar-ter of 1983, a technique reportedly used with somesuccess 10 years earlier vis-à-vis the same coun-try. The International Monetary Fund, also activein the debt rescheduling exercise, has not publiclyobjected to this threat” (Diaz Alejandro, 1985: 12).For Latin America as a whole, before the outbreakof the crisis in 1982, around two thirds of the lend-ing by United States banks was to private sectorborrowers. In 1983, the first year of debt restruc-turing, the share of publicly guaranteed debt roseto two thirds, and eventually reached 85 per centin 1985 (UNCTC, 1991).

This process of protracted negotiations be-tween banks and debtors, with the intermediationof international financial institutions (a strategywidely described at the time as “muddling through”),continued for several years without making a dentin resolving the problem and removing the debtoverhang. Highly-indebted developing countriesincreasingly questioned the rationale of engagingin such Ponzi financing – whereby they had tokeep on borrowing in order to service their debt –which eventually pushed some of them into de-fault on interest payments and led to legal battleswith the banks. On the other hand, creditors toobecame highly sceptical of the merits of “puttinggood money after bad”, and started to dispose ofsuch debt in secondary markets as they accumu-lated adequate provisions. Through the BradyPlan, the resolution of the crisis eventually in-volved the private sector, but only after costingthe debtors a lost development decade.

In more recent episodes of financial crisis inemerging markets, creditor banks were again ableto organize themselves into groups to conductnegotiations with the debtors – with the Republicof Korea in January 1998, and with Brazil inMarch 1999. Again, in both cases negotiations and


agreements came only after the deepening of thecrisis. In the case of Brazil, banks were unwillingto roll over debt in late 1998 and agreement wasreached only after the collapse of the currency.The Government of the Republic of Korea hadalready suspended payments at the end of Decem-ber 1997 and, as recognized by the IMF, “… theagreement to stabilize interbank exposure toKorea was struck … when it was generally rec-ognized that reserves were almost exhausted andthat, absent an agreement, a default was inevita-ble” (IMF, 2000f: footnote 26). A number of bankshad already left, which contributed to the turmoilin the foreign exchange market.

While the rescheduling of debt providedsome breathing space in both cases, the impactwas far less than what could have been achievedwith timely standstills. As theGovernment of the Republicof Korea noted in its subse-quent report to the G-20, “Manyof those who have analysedKorea’s 1997–1998 crisis con-tend that Korea could havesolved its liquidity problemssooner had a standstill mecha-nism been in place at the timeit requested IMF assistance”(Ministry of Finance andEconomy, Republic of Korea,1999: 13), that is, at the endof November 1997.20 In Indonesia, restructuringcame even later than in the Republic of Korea(eight months after the first IMF programme) andmade very little impact on stabilizing the econo-my.21

More significantly, such debt restructuringexercises can hardly be portrayed as examples ofthe private sector bearing the consequences ofthe risks it had taken. In the restructuring in theRepublic of Korea, private debts were effectivelynationalized via a government guarantee. Thiswas also the case for subsequent reschedulingsby Thailand and Indonesia. Moreover, creditorsended up better after the rescheduling; there wasno debt write-off but simply a maturity extension,with new loans carrying higher spreads than theoriginal loans. Although the maturity extensionspreads were considered to be relatively low, par-ticularly compared to the IMF’s Supplemental

Reserve Facility (SRF), such a comparison over-looks the fact that the original bank loans alreadycarried a risk premium.22

Problematic as they are, it is found that suchrestructuring exercises cannot be replicated inmany other countries. According to the IMF, “thesuccess of the Korean operation reflected two spe-cific features, which are unlikely to apply to othercases. First, Korea maintained a restrictive capi-tal account regime that forced a high proportionof imported foreign saving to be channelledthrough domestic banks … Second, at the onsetof the crisis, the sovereign external debt burdenwas very low. As a result, the extension of a sov-ereign guarantee … did not place excessive bur-den on the sovereign” (IMF, 1999: 41–42). It isthus recognized that debt restructuring with for-

eign banks can run into seri-ous difficulties when debtorsare widely dispersed and thecapital account is wide open.The latter feature could indeeddiscourage creditor banksfrom entering into restructur-ing since it would allow otherinvestors to exit at their ex-pense. It is also recognized thata concerted rescheduling of in-ternational private bank debtin emerging markets wouldrequire sovereign guarantees –

a practice inherited, as noted above, from the1980s – though this is not consistent with the es-tablished principles of orderly workouts of pri-vate debt.

A further difficulty with such concerted re-scheduling operations is that they require theexertion of moral suasion by the supervisory au-thorities of creditor banks. This gives considerablediscretionary power to major industrial countries,that may not apply it in a predictable and equita-ble manner to different episodes of crisis. Asrecognized by the IMF, “supervisory authoritiesare likely to be reluctant to exert moral suasionover the commercial decisions of the banks undertheir supervision except in the most extreme cir-cumstances, especially in the context of debtorsthat do not pose a systemic threat to the nationalor international banking system” (IMF, 1999:41–42). Again, this means that “non-systemic

“Many of those who haveanalysed Korea’s 1997–1998 crisis contend thatKorea could have solved itsliquidity problems soonerhad a standstill mechanismbeen in place at the time itrequested IMF assistance.”


countries” would have no option but to imposeunilateral standstills.

Thus it appears that, for international bankloans, too, there are serious difficulties in reach-ing orderly and timely workouts on a voluntaryand concerted basis in order to stem self-fulfill-ing debt runs and ensure that the creditors bearthe consequences of the risks they take. As in thecase of bonds, certain ex ante contractual arrange-ments can help facilitate orderly workouts. One

possibility would be to introduce call options ininterbank credits lines that would provide an au-tomatic rollover under certain conditions, such asa request for IMF assistance by the debtor coun-try. However, unless all debt contracts incorporatesuch automatic standstill clauses, including themin interbank lines alone can be counterproductiveas it can trigger capital flight as soon as a debtorcountry runs into financial difficulties and entersinto negotiations with the IMF. But such clausesare unlikely to be introduced voluntarily.

F. Conclusions

It thus appears that an effective and viablestrategy for private sector involvement in finan-cial crises in emerging markets would be tocombine voluntary mechanisms designed to fa-cilitate debt restructuring with internationallysanctioned temporary standstills to be used whenneeded. These arrangements need to be accompa-nied by the provision of international liquidityaimed primarily at helping debtor countries tomaintain imports and economic activity, ratherthan to maintain open capital accounts and allowprivate creditors and investors to escape the cri-sis without losses. In general, normal access toIMF facilities, appropriately adjusted to allow forthe expansion of world output and trade, shouldmeet such needs. While in some cases additionalfinancing may be required, it should also be rec-ognized that, once exceptions are allowed ongrounds of preventing global spillovers and sys-temic instability, they could easily become therule, thereby aggravating the moral hazard prob-lem. In this respect, the minimum strategy shouldbe to require private participation, once officialfinancing is raised above the normal lending lim-its – or a threshold level – as suggested by someof the Directors at the IMF Board.

Much has been written on the pros and consof officially sanctioned payment standstills in theresolution of financial crises in emerging markets.There is strong resistance by some major creditorcountries as well as private investors to a manda-tory temporary stay on creditor litigation on thegrounds that it would give rise to debtor moralhazard and weaken market discipline. That thisneed not be the case has been argued forcefullyby the Deputy Governor of the Bank of England:

Some have argued that articulating a clearerrole for standstill may perversely alterdebtor incentives, by weakening the pre-sumption that debtors should pay their debtsin full and on time. But an orderly standstillprocess should support, not supplant, mar-ket forces and market disciplines. Corporatebankruptcy law grew up as it became clearthat market forces delivered losers as wellas winners and that some orderly means wasneeded of dealing with the losers. In thisway, bankruptcy law supports the marketmechanism.

The situation is no different in a sovereigncontext. A well-articulated framework fordealing with sovereign liquidity problems


should reduce the inefficiencies and ineq-uities of the current unstructured approachto standstills. It would support the interna-tional capital market mechanism. It wouldbe no more likely to induce debtors todefault than bankruptcy law is to induce cor-porate debtors to default. (Clementi, 2000)

Another concern is that the threat of a stand-still could accelerate capital outflows, therebyaggravating the crisis. Indeed,that is why standstills and ex-change controls need to be im-posed rapidly, and why thedecision to do so should restwith the country concerned.Furthermore, as noted above,the threat of suspension ofpayments could provide an in-centive for creditors to engagein voluntary solutions, particu-larly for sovereign debt, there-by avoiding the need to im-pose standstills.

It is also argued that standstills could makeit difficult for the debtor country to regain rapidaccess to international financial markets, forcingit to make painful trade adjustments or to continueto rely on official financing. But that is preciselywhy such decisions can be expected to be takenwith prudence. After all, countries that may needto impose temporary stand-stills are likely to be those thatare closely integrated with in-ternational financial marketsand would stand to lose if thedecision was not exercisedwith care and prudence. In thisrespect, the recent Malaysianexperience holds some usefullessons. The measures adoptedby Malaysia included tempo-rary and selective paymentsstandstills, which sought toprevent the deepening of thecurrency crisis and widespreadinsolvencies. There was nosignificant outflow of capitalwhen the controls were lifted in September 1999,and the country enjoyed an upgrading of its for-eign currency credit in December of the same year

as well as the normalization of relations with in-ternational capital markets.23

There is concern among policy makers insome emerging-market countries that the inclu-sion of internationally sanctioned standstillsamong the arsenal of measures for managingand resolving financial crises and the tying of theprovision of large-scale emergency financingto greater involvement of the private sector

would limit their access tointernational capital marketsand would also reduce privatecapital flows to their econo-mies. Such concerns are par-ticularly widespread in mid-dle-income countries with lowsaving and investment ratesand uneven growth perform-ance, and with only limitedsuccess in attracting greenfieldFDI in tradeable sectors andachieving a stronger exportbase. Such countries are heav-

ily dependent on financial inflows to meet cur-rent-account deficits that tend to increase rapidlyas soon as domestic demand picks up.

The measures advocated here will almost cer-tainly somewhat reduce aggregate financial flowsto emerging markets by deterring short-term,speculative capital. However, this outcome would

have a beneficial side, sincesuch capital flows add littleto the financing of develop-ment, while provoking signifi-cant instability and leading toa stop-go pattern of growth(see TDR 1999, chap. V, andTDR 2000, chap. IV). In thissense, arguments in favour ofsuch measures have a ration-ale similar to those in favourof regulation and control ofshort-term, speculative capitalinflows. There is often a temp-tation for countries to rely onsurges in financial inflows,while paying insufficient at-

tention to their longer-term consequences. However,it is difficult to attain rapid and sustained growthwithout undertaking the reforms needed to address

The threat of suspension ofpayments could provide anincentive for creditors toengage in voluntarysolutions, particularly forsovereign debt, therebyavoiding the need toimpose standstills.

The measures advocatedhere will almost certainlysomewhat reduceaggregate financial flows toemerging markets bydeterring short-term,speculative capital.However, this outcomewould have a beneficialside.


structural and institutional impediments to capitalaccumulation and productivity growth – reformswhich will reduce dependence on financial inflows.

As noted above, the risk of spillovers andcontagion to other emerging markets seems to bethe main reason for the reluctance of internationalfinancial institutions to encourage standstills incountries that are consideredimportant for the stability ofthe system as a whole. Variouschannels of contagion havebeen mentioned in this context,including cutting exposure toother countries, liquidating as-sets held in other markets inorder to meet margin pay-ments, or a general withdrawalof funds from emerging mar-kets (IMF, 2000f: 22). How-ever, the introduction and useof standstills as part of stand-ard tools in crisis interventionwould influence investor andcreditor behaviour and portfo-lio decisions, which could re-sult in reducing such potentially destabilizinginterdependences. More importantly, as notedabove, such orderly debt workout mechanisms arequite different from messy unilateral defaults intheir impact on the functioning of internationalfinancial markets.

Perhaps one of the most important potentialbenefits of binding in and bailing in the privatesector is the possible impact on policy-making inthe major creditor countries. Interest rate and ex-change rate policies in these countries exert a sig-nificant influence on the competitiveness, balanceof payments and capital flows of debtor develop-ing countries, which cannot always be counteredwith domestic policy adjustment. Indeed, mostmajor financial crises in emerging markets have

been associated with sharp swings in exchangerates, interest rates and market liquidity in themajor industrial countries. The latter have notalways paid attention to the global repercussionsof their policies, mainly because adverse spilloversto their financial markets from emerging-marketcrises have been contained, thanks largely tobailout operations. Nor has the IMF been able to

deal with unidirectional im-pulses resulting from changesin the monetary and exchangerate policies of the UnitedStates and other major OECDcountries, in large part becauseof shortcomings in the exist-ing modalities of multilateralsurveillance (Akyüz and Corn-ford, 1999: 31–33). Burdensharing by creditors in emerg-ing-market crises can thus beexpected to compel policymakers in the major industrialcountries to pay greater atten-tion to the possible impact oftheir policies on emergingmarkets. Indeed, it appears

that the potential for adverse spillovers from thecrisis in the Russian Federation played a crucialrole in the decision of the United States FederalReserve to lower interest rates in late 1998, eventhough, on the eve of the Russian default, the Fedwas widely expected to move in the opposite di-rection. As is well known, the default caused con-siderable losses to Western investors and credi-tors, and threatened to set a precedent regardingcompliance of emerging markets with their exter-nal obligations. Thus, it can be expected that ef-fective mechanisms designed to involve the pri-vate sector in the resolution of emerging-marketcrises could bring a greater global discipline topolicy-making in the major industrial countries –something that multilateral surveillance has so farfailed to achieve.

Effective mechanismsdesigned to involve theprivate sector in theresolution of emerging-market crises could bring agreater global discipline topolicy-making in the majorindustrial countries –something that multilateralsurveillance has so farfailed to achieve.


1 For an analysis of the policy response to the Asiancrisis, see TDR 1998 (chap. III), and TDR 2000(chap. IV).

2 A wider use of the concept includes greater trans-parency in standards of policy-making and improveddata dissemination, as these measures are seen tobe essential for markets to appropriately assess andprice risks (IMF, 2000g, chap. V).

3 According to the Institute of International Finance,losses incurred by private investors since 1997 inemerging- market crises have amounted to $240billion for equity investors, $60 billion for interna-tional banks and $50 billion for other privatecreditors on a mark-to-market basis (Haldane,1999: 190). Losses incurred by foreign banks in theAsian crisis are estimated at some $20 billion (Zonisand Wilkin, 2000: 96).

4 Losses resulting from daily adjustments to reflectcurrent market value, as opposed to historic account-ing (or book) value.

5 On the private sector position, see IIF (1999), andIMF (2000g).

6 Unless stated otherwise, all quotations that followin this section are from the same source (i.e. IMF,2000h). For a more detailed discussion, see IMF(2000f). Temporary suspension was proposed in anearlier Working Party report to the Group of Ten:“… in certain exceptional cases, the suspension ofdebt payments may be a necessary part of the crisisresolution process” (Group of Ten, 1996: 3). Sub-sequently, it was supported by the Council on For-eign Relations Task Force (CFRTF); see CFRTF(1999).

7 This was also first proposed by the G-10 WorkingParty: “Such lending can both signal confidence inthe debtor country’s policies and longer-term pros-pects and indicate to unpaid creditors that their in-terest would best be served by quickly reaching anagreement with the debtor” (Group of Ten, 1996: 3).

8 On the “comparability of treatment” principle andits recent application, see Buchheit (1999); De laCruz (2000); and IMF (2000g).

9 For this so-called problem of “the inconsistency ofoptimal plans”, see Kydland and Prescott (1977).

10 See Miller and Zhang (1998). The same argumentsabout the ineffectiveness of official assistance policyin securing private sector involvement in crisis reso-lution were used in favour of the introduction ofcollective action clauses in bond contracts in orderto facilitate restructuring (see Eichengreen and Ruhl,2000).

11 A notable exception to calls for smaller IMF pack-ages is the so-called “Meltzer Report” (see Interna-tional Financial Institutions Advisory Commission,2000). For a discussion of the debate on IMF crisis-lending, see Goldstein (2000).

12 In creating this facility all Fund members wouldagree to donate their share of the allocation to thefacility and there would also be agreement that onlydeveloping countries would be entitled to draw onthe facility. This clearly differs from another pro-posal, which is to allow the Fund to issue reversibleSDRs to itself for use in lender-of-last-resort op-erations - that is to say, the allocated SDRs wouldbe repurchased when the crisis was over. See Ezekiel(1998); United Nations (1999); and Ahluwalia(1999).

13 Acceleration clauses allow creditors to demand im-mediate repayment of unpaid principal following adefault. Under cross-default (or cross-acceleration)clauses, creditors are entitled to bring forward theirclaims if the debtor has defaulted on other debts.Put options allow creditors to demand repaymentahead of the scheduled contract date, under certainconditions.

14 See, for example, Group of Ten (1996). This recom-mendation has been reiterated following the Asiancrisis (see Group of Twenty-Two, 1998). For a dis-cussion of problems in bond restructuring andCACs, see Eichengreen and Portes (1995); Dixonand Wall (2000); and Buchheit (1999).

15 In the case of English-law bonds issued under a trustdeed, the trustee represents the interest of all bond-holders and shares any proceeds recovered on a pro

Notes


rata basis. However, trustees rarely exist for sover-eign issues (Yianni, 1999: 79–81; Dixon and Wall,2000, box 1).

16 For some recent experiences of bond restructuringby emerging markets, see box 6.2.

17 This is also recognized by the IMF (2000f: 16).18 The Bulgarian case of 1996–1997 is cited as an ex-

ample of such market breaks leading to litigations(Miller and Zhang, 1998: 16).

19 See, for example, IMF (1999: 41–42; and 2000b,chap. V); and Eichengreen and Ruhl (2000: 5, foot-note 7).

20 For support of this position based on a study of theMalaysian capital controls, see Kaplan and Rodrik(2000, particularly pp. 27–28).

21 For a description of the East Asian restructuring seeRadelet (1999: 66–67).

22 The deal included a total debt of $21,740 millionowed to 13 banks, and the maturities were extended

from one to three years, involving spreads between225 and 275 basis points. The spread on SRF was300 basis points – lower than the maximum spreadon maturity extension mentioned in the previousnote (Ministry of Finance and Economy, Republicof Korea, 1999: 14).

23 See TDR 2000, box 4.1. This situation was also rec-ognized by the IMF: “They [Malaysia’s controls]do not appear to have had any significant long-termeffect on investor behavior” (IMF, 2000f, foot-note 28). While it is suggested that “capital controlsmay have contributed to a decline in FDI” comparedto the Republic of Korea and Thailand (ibid.: 24),it is quite likely that an important aspect of thestronger recovery of FDI in those two countries in1999 was the spate of fire-sale investments andtakeovers associated with the collapse of asset pricesand exchange rates.

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