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CHAPTER 3

IMF INVOLVEMENT IN ASIA: AN INSTITUTION IN NEED OF MAJOR REFORM OR A STABILIZING FORCE?
A. Is the IMF Rescue Attempt Warranted?
B. Has the IMF Response in Asia been Appropriate?
C. Improving the Structure of the Global Financial System
D. The Case for and against Controlling Short-Term Capital Flows
1. The Case for Controls
2. The Pitfalls of Controls

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IMF INVOLVEMENT IN ASIA: AN INSTITUTION IN NEED OF MAJOR REFORM OR A STABILIZING FORCE?

The International Monetary Fund (IMF), the global institution charged with safeguarding the stability of the international monetary system, has been called in to help remedy the Asian financial crisis. Should the IMF be involved at all in this mammoth rescue effort? Does the IMF’s involvement increase the chance of future crises? Or are the conditions attached to IMF assistance sufficient in magnitude to deter the players involved from making the same mistakes again? Is the tough medicine the IMF prescribes an overreaction to the problem, or necessary to gain investor confidence? What reforms are needed to the international financial system to prevent future financial difficulties of the Asian kind? Can global capital flows be controlled without the imposition of sizeable economic costs? These are the questions discussed in this chapter.

A. Is the IMF Rescue Attempt Warranted?

During the past year, the IMF has put together a total of over US $100 billion in financial rescue packages to assist firms and banks in South Korea, Indonesia, and Thailand, thereby helping to stabilize their economies. The IMF’s role as the international lender of last resort has come under intense scrutiny from all parts of the political spectrum.

The major criticism of the Fund’s participation in this crisis is that its intervention can lead to what economists refer to as "moral hazard" problems. In Asia, the bulk of the financial assistance has been channelled through the recipient governments and their central banks to the private banking system. The worry is that creating more of a safety net in the form of bank bailouts will only encourage bankers and investors to indulge in reckless financial activities of the kind that helped put the Asian countries in need of rescue in the first place. While not all investments that were made can be placed in the "reckless" category, many were associated with risky ventures and unsound projects.

With these "bailouts," the critics argue, the IMF is sending a message to investors and speculators, foreign and domestic, that their losses will be limited. Allowing the IMF to continue to act as lender of last resort, even if it stabilizes the financial situation in the short run, allows those bankers and money managers responsible for having made foolish decisions to avoid the discipline of the marketplace. The knowledge that IMF rescue operations would not be made might introduce greater prudence into lending activities.

Also, IMF money is said to effectively prop up undeserving regimes by letting governments off the hook for encouraging and even benefiting from destructive policies and practices. These range from corruption, to inefficient central planning, to state mismanagement, to preferential regulation, not to mention the lack of secure property and contract rights. Denying access to rescue assistance would make it more difficult for policymakers to persist with bad policies.

There are those who believe that the knowledge that the IMF was there as a lender of last resort, ready to bail out those lending institutions that were not demonstrating sufficient prudence in their lending activities, was a factor in the evolution of the Asian crisis. Following this line of reasoning, reduced accessibility to IMF resources after the Mexican peso crisis might have prevented these recent adverse developments.

In addition, critics of the IMF point to the considerable expense required to fund its rescue operations. IMF financial resources are provided primarily through the quotas, or membership fees, paid by member countries such as Canada. Negotiations to expand such quotas by US $90 billion (representing a 45% increase) were authorized by finance ministers at the September 1997 annual meetings of the IMF and World Bank. Given recent developments, even further financial infusions could be requested. The nature of the funding for the IMF, however, is misunderstood by many of these critics in that it does not require a budget outlay but rather is treated on the books as an investment. As such, IMF contributions earn market-related rates of interest in much the same way as does a deposit in a credit union.⁽²⁵⁾ On the other hand, whether or not taxpayers are at risk ultimately depends on the likelihood of an IMF default.

Some of those advocating a reduction in the IMF’s role as international lender of last resort would like to see the institution’s primary function become one of providing impartial outside auditing of conditions within the countries under its purview. By "giving a country the equivalent of a "Good Housekeeping seal of approval" the IMF would have a profound impact on the way in which financial markets would perceive the risks associated with investing there. In the end, what a country must win is the sympathies of the financial markets, since the amounts provided by the IMF, although often large, are small by comparison with countries’ overall financing requirements. The audit process of the IMF should, in turn, be based on results, not on the policy mix the country adopts."⁽²⁶⁾

The problem with the above approach is that the ability of the IMF to foresee developing problems within countries at an early-enough stage is not impressive. Even though the Fund undertook to register a significantly better performance in its economic surveillance role following the Mexican peso crisis, it still failed to raise the alert on East Asia’s financial troubles. Instead, the IMF gave high marks to many of these regional economies right up to the onset of the crisis. For example, the IMF’s World Economic Outlook 1997, issued shortly before South Korea’s economic miseries became public knowledge, did not anticipate a crisis in that country. Indeed, the report projected that South Korea would enjoy growth of 6% in 1998.

Yet the IMF approach can be defended. To counter the all-important "moral-hazard" argument, the IMF itself emphasizes that most investors in East Asia – equity investors and many of those who lent to corporations and banks – have, in fact, taken heavy losses in currency and equity markets and that many firms and financial institutions (both foreign and domestic) have experienced serious, if not fatal, financial difficulties.⁽²⁷⁾ Mr. Robert Solomon (Guest Scholar, Brookings Institution) agreed with this view, pointing out to the Committee that private interests "are not shielded from losses just because the IMF steps in to lend to a country with an ailing balance of payments" (15: 6).

In addition, it is not clear why governments would want to trigger international assistance by encouraging a financial crisis. "To begin with, the notion that the availability of IMF programs encourages reckless behaviour by countries is far-fetched; no country would deliberately court such a crisis even if it thought international assistance would be forthcoming. The economic, financial, social, and political pain is simply too great; nor do countries show any great desire to enter IMF programs unless they absolutely have to."⁽²⁸⁾ In addition, the chances of individual policymakers surviving financial crises politically is often severely reduced.

"It is not clear how the free market would reform crony capitalism as it exists in Indonesia and Korea, nor how market mechanisms would separate the cosy relationships of Korean banks and conglomerates, nor how the free market would introduce more effective supervision and transparency into the banking systems of these countries."

(Mr. Robert Solomon, Guest Scholar, Brookings Institution)

Fund supporters also employ the argument that the attachment of stringent conditions to IMF funds provides adequate assurance that similar crises would not occur again, thereby removing the "moral-hazard" problem. In the case of Thailand, Indonesia, and South Korea, all these countries have agreed to make significant changes in their economic policies and financial sector practices. Each of them has been required to bring greater transparency and accountability to their shattered financial systems, in the process removing the collusion between the state, banks, and business, as well as opening up their domestic financial markets to outside interests. There is no doubt that the IMF has demanded difficult – many would say too difficult – reforms as the quid pro quo for its financial assistance. Without the possibility of conditionality, it is pointed out, these reforms might not take place or could be deferred.

The key argument in defence of the Fund, however, involves the ramifications of inaction, both in the region itself and globally. Without IMF intervention, proponents note, individual countries’ currency markets would have suffered steeper declines, and a greater incidence of corporate bankruptcy would have occurred.⁽²⁹⁾ One can even imagine the possibility that, in the absence of IMF conditional official financing, East Asian countries could have responded to increasing external deficits with greater use of competitive devaluations and even with trade and exchange controls.⁽³⁰⁾ Such a response would have intensified the problem.

"¼ the IMF is the only institution that can co-ordinate action when sovereign nations are involved. We are talking about fast moving, global financial crises that demand large and immediate injections of credit. Since the foundation for global growth is increasingly in international financial intermediation, we cannot risk a collapse of the international financial system. There is a real role for the IMF."

(Ms. Catherine Mann, Senior Fellow, Institute for International Economics)

Moreover, given the size and speed of global private capital flows, the need for an ultimate line of defence against financial crises is especially great. By doing nothing to contain the initial damage, it is argued, the current difficulties would spread to other regions of the world, with serious repercussions for the global economy. For example, if companies in South Korea and other parts of Asia were to default on their debts, thereby affecting Japanese financial institutions and, indirectly, other developed countries’ financial markets and economies, a serious world-wide economic recession or even depression could occur.⁽³¹⁾ According to IMF proponents, the risks of inaction associated with possible contagion effects outweigh those associated with the provision of financial assistance.

In the aftermath of the 1994-95 Mexican peso crisis, the IMF played a key role in dealing with the crisis and ensuring that contagion effects were not experienced in the rest of Latin America. In the present Asian situation as well, the global economy has not experienced disastrous declines in its rate of economic growth, at least not yet. In the case of Asia, the risks associated with inaction on the part of the IMF were not viewed to be worth assuming.

The Committee is of the view that abolition of the IMF would represent an extreme response and one that would be decidedly unpopular with the institution’s member countries. An international lender of last resort can lessen the impact of contagion on neighbouring countries "irrationally" affected by financial crises elsewhere. By placing conditions on its financial assistance rescues, it can also prompt the policy and institutional changes required rendering economies more efficient. For these and other reasons, we believe that it would be far better to alter the IMF’s mandate and operations so as to enable it to become a more effective global institution, rather than to engage in its dismantling.

 

B. Has the IMF Response in Asia been Appropriate?

When the IMF enters into financial rescue agreements with countries, recipients of IMF loans necessary to meet foreign-debt obligations are expected to undertake sizeable economic and policy adjustments. In exchange for billions of dollars, recipient governments are requested, through the imposition of tight monetary policy, to ratchet domestic interest rates upward to halt the flight of capital and to help stimulate investor and lender interest in the affected countries. Countries are also asked to tighten up their fiscal positions, to deal with the future costs of financial restructuring and, in certain cases, the need to reduce the current account deficit. With the present financial and economic situation showing signs of deterioration, this latter requirement has been loosened considerably by the IMF.

The third and final requirement is that the affected countries embark quickly on the task of restructuring their financial sectors and improving financial regulation and supervision. Indeed, financial sector restructuring and other structural reforms (e.g., to disentangle and make more transparent the relationships between governments, banks, and firms) lie at the heart of each of the three East Asian programs entered into by the IMF. One can add to this list the prescribed opening up of Asian markets to foreign participants, a source of considerable resentment on the part of many Asians. According to the IMF, the reform of banks, finance companies, conglomerates and government monopolies is an important precondition to countries regaining confidence and market access to private sector financing.

It should be made clear that the IMF only gets involved in such rescue attempts, and the associated reform conditions, at the request of the financially troubled country itself. Typically, the request comes in at a time when the value of the currency in question is plummeting, and often when foreign exchange reserves are being rapidly depleted, as was the case in Thailand and South Korea. In these instances, the recipient country normally considers the Fund, at least in the initial stages of the crisis, to be a welcome friend. ⁽³²⁾

"The counter argument that the fund and others make is that, on the monetary side, you need sufficiently high interest rates so that people are willing to hold that domestic currency. Yes, if interest rates are kept too high, then the financial system and domestic borrowers will suffer. However, many of these domestic corporations have huge foreign currency liabilities. If the currency is not stabilized, they will lose because of the burden of servicing these foreign currency debts. The IMF is sort of caught between a rock and a hard place."

(Mr. James Powell, Deputy Chief, International Department, Bank of Canada)

The IMF thinking is that when a currency is in sharp decline, what is needed to stem the outflow of capital is a sharp, albeit temporary, increase in interest rates. As capital returns and private sector confidence and economic stability is restored, interest rates can then decline without much overall harm to the economy. According to the IMF, "nobody has invented another way of re-establishing confidence, when exchange rates are plummeting or going down into the abyss, than to reactivate monetary policy and to bring interest rates to a level which could create not the sufficient conditions, but at least the necessary conditions for confidence to be re-established."⁽³³⁾

The alternative, according to the IMF, is to let the currency continue to slide. This response, however, is damaging to firms with sizeable foreign currency debts, who are hurt more by a sharp reduction in the exchange rate than by a "temporary" increase in interest rates. "Moreover, when interest rate action is delayed, confidence continues to erode. Thus, the increase in interest rates needed to stabilize the situation is likely to be far larger than if decisive action had been taken at the outset. Indeed, the reluctance to tighten interest rates forcefully at the beginning has been an important factor in prolonging the crisis."⁽³⁴⁾

This process of placing tough IMF conditions on the receipt of rescue funds often leads to difficult employment and income losses and therefore is unpopular with the citizens of the country in question. If prolonged, any resulting economic slump could lead to political opposition to the mandated reforms and to the prospect of entrenched commercial and bureaucratic interests regaining the upper hand.

Irrespective of whether the IMF should be involved at all in helping Asian countries, opinions vary on whether the form of the rescue effort has been appropriate. Up to now, the financial crisis in Asia has shown few signs of abating. Those supporting the IMF’s traditional rescue models argue that such a result can be explained by the fact that there was an initial reluctance on the part of Asian leaders to implement the requested changes. This deficiency has since been at least partly rectified as countries such as Indonesia and South Korea have, grudgingly perhaps, responded to IMF demands.

Historically, the IMF has provided emergency assistance to bankrupt governments (e.g., Mexico in 1994-95; Latin American countries in the 1980s) and has not dealt with the foreign debts of banks and industrial firms. The difficulties typically addressed by the IMF – high budget and trade deficits – were, in the case of Indonesia and South Korea, not to be found. Rather, the problem areas included non-performing financial systems and crony capitalism, difficulties typically found outside of the IMF’s normal focus. There are those who question whether or not applying the traditional IMF rescue approach to countries whose real (non-financial) economies are sound tends to exacerbate rather than reduce the crisis at hand.

Essentially the IMF is addressing a temporary liquidity crisis in countries’ corporations and banks, rather than a fundamental insolvency problem. Increasingly, the Fund has turned its attention to managing microeconomic issues in an effort to remove structural barriers to macroeconomic stability and sustained growth. These issues include rectifying the deficiencies in domestic financial systems and enhancing the transparency and accountability in government and corporate affairs, to name two of many.

This new-found focus has led many to question the level of intrusion of the IMF into what is often viewed as the day-to-day domestic affairs of individual sovereign countries. A new resentment of the IMF – and by extension the United States, viewed as the main force behind the Fund’s interventionist action – is building in the Asian countries most affected by the crisis. This resentment over the perceived loss of sovereignty is increasingly leading to a new-found expression of nationalism and opposition to the forces of globalization which have subjected the region to outside influences.

Critics of this aggressive and comprehensive approach say that imposing conditions on IMF lending is seriously aggravating the situation in the real economy of the countries affected. Equally important, the IMF’s intervention is leading the organization far astray from its original mission; namely, to provide short-term liquidity to countries experiencing balance-of-payments problems. What was urgently required was a rollover of short-term corporate debt, not the IMF’s traditional medicine of domestic austerity and the imposition of a Western economic system, measures deemed by many not to be helpful in dealing with balance of payments problems. "The IMF should provide the technical advice and the limited financial assistance necessary to deal with a funding crisis and to place a country in a situation that makes a relapse unlikely. It should not use the opportunity to impose other changes that, however helpful they may be, are not necessary to deal with the balance-of payments problem and are the proper responsibility of the country’s own political system."⁽³⁵⁾

Much of the criticism of the IMF centres on the Fund’s use of austerity programs in association with its financial-rescue initiatives. Fewer and fewer people remain convinced that the typical policy prescriptions introduced by the IMF (e.g., high interest rates, increased taxes, budget cuts, etc.) will put an end to the Asian financial crisis and result in an improved reconfiguration of financial markets. In this vein, the Fund has come under attack from Joseph Stiglitz, the high-profile chief economist of the World Bank and former Chair of President Clinton’s Council of Economic Advisors. Mr. Stiglitz has maintained that the IMF’s austerity measures have kept investors away and have caused a certain degree of panic. He is of the view that the Fund has exaggerated the crisis in countries that used to have low inflation, balanced budgets, and high savings rates. Through its insistence on high interest rates, sharp declines in public spending, and bank closures in exchange for IMF financial assistance, investors have become informed of the country-associated risks and have been frightened away needlessly. This response has led to a flight of capital away from both stable and troubled firms to safety (U.S., Europe).

More specifically, Mr. Stiglitz has questioned whether the imposition of higher interest rates has provided the appropriate incentive to investors and lenders, and therefore has restored the desired confidence. His view is that high interest rates send a signal to investors that the potential for default on the part of many, if not all, borrowers has risen significantly. As a result, capital departs and the affected currencies fail to recover, as the reality of the Asian situation demonstrates. In fact, the higher rates have depressed local economies without preventing major erosions in currency values. Healthy firms have been less able to service their debts or to finance economic activity, such as export generation. In the meantime, other IMF austerity conditions, such as the call for reduced government spending, the request for price hikes, and the shutting down of insolvent banks worsen economic performance.

Jeffrey Sachs, a professor of economics at Harvard University, concurs with this assessment, arguing that the IMF’s austerity policies have led to a serious credit crunch, have substantially increased the bankruptcy rate amongst firms and have led to higher rates of capital flight. Sachs argues that the IMF’s imposed austerity measures and bank closures have caused the financial crisis in Asia to worsen. "Suddenly, many of the leading banks in Asia have stopped making loans, just like their foreign counterparts. They are more interested in improving their balance sheets (by increasing capital and liquidity) than they are in extending credits to enterprises. High interest rates demanded by the IMF, combined with a cut-off of domestic bank loans, and the withdrawal of foreign credits, are rapidly pushing many otherwise healthy enterprises into bankruptcy."⁽³⁶⁾ According to Sachs, in all three Asian IMF bailout situations, local currencies and equity markets have been driven down even lower as a result of country responses to IMF demands.

Martin Feldstein, writing in Foreign Affairs, also has been quite critical of the traditional IMF structural adjustment approach, arguing that they were not required in the case of South Korea. Instead, "the primary need was to persuade foreign creditors to continue to lend by rolling over existing loans as they came due. The key to achieving such credit without an IMF guarantee of outstanding loans was to persuade lenders that Korea’s lack of adequate foreign exchange reserves was a temporary shortage, not permanent insolvency. By emphasizing the structural and institutional problems of the Korean economy, the fund’s program and rhetoric gave the opposite impression. Lenders who listened to the IMF could not be blamed for concluding that Korea would be unable to service its debts unless its economy had a total overhaul."⁽³⁷⁾

For its part, The Economist magazine has argued that East Asia’s problem was one of a highly inefficient financial system, not high inflation and fiscal excesses. It questions whether the IMF’s traditional remedy of restrictive fiscal policy and tight monetary policy designed to curb inflation and support the currency, is appropriate. It argue that while fiscal policy may deserve a small degree of tightening, the IMF’s prescribed approach of tax hikes and spending reduction has been on the excessive side and counterproductive, which even the Fund has come to realize. In the past, the IMF has been flexible on fiscal targets when growth turns out to be weaker than expected, and it has since backed off from prescribing its stiff fiscal medicine. However, increasingly it is becoming recognized that its tight monetary prescription is hampering the recovery process.

Finally, the Fund – and the U.S. government – has been criticized for having salvaged the profit margins of the international banks and their large borrowers. While some banks have added to their loan loss reserves to account for potential future write-offs, not all have. Moreover, the amounts that have been set aside have been quite modest.⁽³⁸⁾ Whereas bank losses have been minimal, increased taxation and additional currency devaluation have hit hard the citizens of the affected countries.

The financial and economic situation in East Asia continues to be poor; indeed, preliminary indications are that the IMF’s policy prescriptions have been counterproductive. Tight monetary policy has not instilled investor confidence in the way that it was hoped it would, and the Fund’s prescribed austerity measures have inflicted much pain and suffering on the populations affected. Even the President of the World Bank, Mr. James Wolfensohn, has come out to say on the record that he would like to see more emphasis placed on social concerns (e.g., unemployment) when financial rescue packages are established. Concerned about the economic costs imposed by the IMF’s response to the Asian crisis, the Committee would like to see a thorough re-examination of the approach used by the Fund undertaken. Ideally, this review would be performed by an independent and high-level entity and would involve an examination of alternative financing options such as the creation of an Asian Monetary Fund. Such a fund, first proposed by Japan in August 1997, could provide quick-disbursing loans to financially-troubled member countries, backed by the sizeable net creditor position of the region(39) . The Committee recommends:

Recommendation 2: That, in order to enhance IMF effectiveness, the federal government propose to other IMF members that a thorough, high-level, and independent review of both the IMF’s overall mandate and its specific strategy in dealing with the financial crisis in Asia be undertaken. Part of this review should be devoted to an assessment of alternative financing arrangements such as the development of a regionally based Asian Monetary Fund. If any future financial assistance packages are required, whether coordinated by the IMF or any other financial group they should take more explicitly into account their impact on the societies affected.

C. Improving the Structure of the Global Financial System

Increasingly, the current global financial system has come under attack. "The main problem is that, even though financial markets are much more integrated than product markets and capital is much more mobile than other factors of production, there is no global governance of international financial transactions analogous to that found in the areas of trade. Moreover, the present international arrangements are not only inadequate but also asymmetrical; they are designed to discipline borrowers rather than regulate lenders. This stands in sharp contrast with the way national financial systems are designed. Moreover, international arrangements are designed to manage rather than to prevent crises."⁽⁴⁰⁾

The Asian financial crisis has made it almost inevitable that there will be a post-crisis attempt to strengthen the global financial architecture. There is a growing consensus that major changes, not just stopgap measures, are required.

Attempts to forge a consensus on the design of this new global financial structure have begun. What is beginning to emerge as a future course of action is a set of initiatives designed to avoid, rather than to manage, future financial crises. Initial measures now being explored include an improvement in the amount and quality of financial data individual countries release to the public; tighter regulation of banks and other financial institutions; and a reduction or elimination of the protections now extended to international banks and investors engaging in risky lending and investing practices.

Definitely, there is a need to improve the "early warning system" implemented, after the Mexican peso crisis, at the Halifax meetings in 1995, under which IMF member countries were to provide clearer pictures of their economic and financial health. As the South Korean situation demonstrates, there remains an urgent need for increased transparency of information about countries’ financial situations. Given that the Fund itself does not have the personnel resources to act as an ongoing supervisor of Asian financial institutions and systems, it is critically dependent upon the countries themselves for the required data. Accurate information on the maturity and currency composition of individual countries’ external indebtedness, foreign exchange reserves, the liability of central banks, the number and value of non-performing loans, and other important criteria needs to be made available to IMF staff in a timely manner. Of course, the need for transparency also extends to the entire structure of countries’ economies (already covered in "Lessons Learned" section) and to the internal activities of the IMF itself (see below).

At the Spring meetings of the IMF and the World Bank held in Washington in April, 1998, the IMF’s policy-setting interim committee adopted a "code of good practices" targeted at raising the quality and timeliness of country reporting on key economic indicators such as foreign debt, reserves, and trade deficits. The basic rationale for the code was to better equip potential investors in their attempts to assess individual countries’ finances. Although no requirement to follow the code has been imposed on national governments, it is the hope of the IMF that private investors will choose to do business more readily with countries that subscribe to the standards, in the process stimulating the release of information in those other countries also hoping to attract investment capital.

Weaknesses in data quality in certain countries and the failure to anticipate potential problems combine to hamper the IMF’s  ability to engage in effective monitoring and surveillance activity, as in the case of East Asia. Well before the onset of the Asia’s financial crisis, there was evidence of a considerable widening of countries’ current account deficits owing to large infusions of foreign capital, excesses in local property markets, weak and corrupt banking structures, and ineffectual bank regulatory systems. While the IMF did attempt privately to alert certain countries to these shortcomings, most notably Thailand a full year before its currency problems materialized, it did not do so in all cases. For example, the severity of South Korean private debt problems was neither known nor anticipated,⁽⁴¹⁾ nor was the Fund successful in predicting the extent of the contagion effects produced by the ever-widening financial crisis. No doubt the IMF will need to improve the effectiveness of its warnings and enhance the quality of its economic forecasts, especially of crises. Otherwise, scepticism about the Fund’s competence in economic surveillance will continue.

Alterations in the mandate and operations of the IMF will be involved in any reform effort. The powers of the IMF are currently limited; for example, it is unable to balance the financial assistance it proffers with measures to convince reluctant political leaders to launch necessary financial and other reforms in advance of a crisis. It cannot unilaterally require member countries to stop excessive foreign borrowing, curtail inappropriate lending practices or carry out "good governance" (e.g., create an adequate legal and institutional framework; implement an open and transparent political system to reduce the incidence of bribery and corruption; etc.). It can only leverage these changes through the conditionality it places on its emergency financing packages, and then only if this assistance is requested of it.

Mr. Bruce Rayfuse (Acting Director, International Finance and Economic Analysis Division, Department of Finance) reminded the Committee that while the IMF can, and does, provide countries with advice on structural reforms, the nation in question is under no obligation to heed that advice unless actual Fund assistance is requested. For example, the IMF claims that it warned Thailand privately of the unsustainability of its high current-account deficit, overvalued currency, inflated real estate values, and weak and overexposed banking system at least a year before the baht experienced difficulty. Regrettably, Thailand chose to ignore that advice until the crisis broke.

On the surface, the obvious solution would be for the IMF to make the country-specific information public. However, this approach has at least two difficulties. The first is that the institution’s access to information and its continuing role as advisor to national governments could be jeopardized by the publication of confidential information. The public release of highly detailed financial information in the form of "bad results" from such a high–profile source as the IMF could also have the undesired effect of precipitating a financial crisis, because presumably some investors would respond to new damaging information by removing their capital.⁽⁴²⁾ Notwithstanding the above risks, the IMF has made some progress in that it is now disseminating more of the data it gathers on member countries, and, at the same time, is attempting to persuade the countries themselves to make more information public.

A second key aspect to the reform effort is the need for tighter supervision of financial institutions and banking systems. Currently, there is no global body with the mandate or the capacity to manage the problem. Prior to the Asian crisis, a committee of worldwide regulators operating under the Bank for International Settlements in Switzerland had made little progress in prompting countries to upgrade international bank regulatory standards. In September 1997, however, the Basle Committee on Banking Supervision released a set of 25 Core Principles for Effective Banking Supervision, designed as a reference guide for bank regulators everywhere(see Appendix 2). Recognizing the validity of international standards and codes of good practices in the banking area, the IMF is currently accelerating its efforts to disseminate this set of "best practices" through its regular surveillance activity. The Committee believes it would be useful if this set of guidelines was formally agreed to by governments in emerging economies. It recommends:

Recommendation 3: That the Government of Canada utilize all available means to encourage governments throughout the world to adopt the Core Principles of Effective Banking Supervision of the Basle Committee on Banking Supervision as regulatory guidelines.

Both Canada and Great Britain are advancing proposals designed to strengthen individual countries’ banking systems by requiring that their regulatory regimes be reviewed and rated by a yet-to-be determined international organization. The Canadian initiative, endorsed by the G-7 leaders in May, would establish an international financial watchdog, a watchdog created to oversee the activities of domestic bank regulators. With staff drawn from existing IMF and World Bank personnel resources, this relatively small "secretariat" would conduct annual reviews of countries’ own financial regulatory systems, including peer reviews by financial experts from a mix of other countries.

The findings of these reviews would be made public for the benefit of potential investors, who would be in a better position to find out if each country’s bank regulators were meeting international standards of accounting and transparency. The hope is that subjecting countries to peer review would place pressure on countries with weaker financial regulation to improve, over time, their regulatory standards and performance. The overall objective would be to prevent, to the extent that this is possible, future Asian-type crises from occurring. Because external financial crises often originate in countries’ banking sectors, it is important to put in place effective regulation of this vital sector.

The Committee shares the view of Canada’s Finance Minister, the Hon. Paul Martin, that an international banking supervisory mechanism is required at the global level. The Committee, believes that such a mechanism should be developed outside of the IMF/World Bank framework so as not to dilute the mandates of these organizations and recommends:

Recommendation 4: That the Government of Canada explore the concept of a global supervisor of domestic bank regulators both bilaterally with individual countries and within international fora. Such international supervisory activity, if any, should only be undertaken outside of the existing IMF and World Bank institutional framework.

"One of the things being discussed now is to get the private sector in early. Rather than have the IMF provide the money, let people get their money out, and then get the banks in. You would get the financial institutions up front, along with the IMF, to work out a solution. In that way, investors do not have a chance to get out with the IMF money."

(Mr. James Powell, Deputy Chief, International Department, Bank of Canada)

Third, focus is also turning to broader IMF reforms that can ensure that financial instability is rectified without the triggering of long-term "moral hazard" problems. Banks that helped fuel the crisis through excessive lending need to pay their share of the costs associated with the financial turmoil. Involving the private sector at a significantly earlier stage in the IMF’s international assistance packages, through such means as debt stand-stills could help ensure that the private sector will contribute to the costs of such rescue proposals, thereby helping to discourage future risky lending behaviour.⁽⁴³⁾ A critical ingredient in these reform efforts is the need for a more orderly rescheduling of private external debt so as to lower the uncertainties that have been prevalent in financial crises. All rescheduling options need to be discussed and considered.

Finally, repeated calls have gone out for the IMF itself to become much more transparent in its own internal decision-making process. Currently, the Fund offers little in the way of public documentation to explain the rationale behind its own decisions, with the result that it is difficult to analyze critically the Fund’s performance. For example, the Fund has not followed the World Bank’s lead in publishing a review of the agency’s effectiveness.

It is ironic that at a time when the Fund is demanding transparency from Asian governments in their respective financial sectors and in the form of their political and corporate governance, the IMF "remains one of the world’s most secretive bureaucracies. The agency’s opacity undermines its credibility and allows the fund to dodge accountability."⁽⁴⁴⁾ Lawmakers in the United States and other countries have been critical of the Fund for demanding capital replenishment without opening the institution to outside scrutiny. The Committee, of the view that there is an urgent need for improvement in this area, recommends:

Recommendation 5: That the Government of Canada persuade other IMF member countries of the need for increased transparency of IMF decision-making and operations. At a minimum, the IMF should be required to provide a full explanation of the conditions, lending terms, and rationale of its lending activities and a more thorough description of the results of its country surveillance efforts.

D. The Case for and against Controlling Short-Term Capital Flows

Throughout much of the 1990s, freedom of movement of capital has been of considerable benefit to emerging markets and developing countries. Capital liberalization has enabled these economies to import not only capital but also ideas and technology, and thus to grow more quickly than would otherwise be the case. As a consequence, living standards have been raised.

However, relatively unrestricted capital movements have also led to increased volatility of short-term capital flows and, according to the IMF itself, to the possibility of a higher frequency of financial crises. "With the increasing globalization of financial markets and the apparent tendency for investors to react exuberantly to success, belatedly to emerging concerns and eventually to over-react as sentiment changes, it may well be that the risk of crises is rising, including the scope for international contagion."⁽⁴⁵⁾

Recent developments in Asia serve as a stark reminder of what can go wrong if economies lacking a sound financial sector rely too heavily on foreign short-term capital. Throughout the decade, many Asian governments were encouraged to take off the controls that had been placed on their capital accounts, thereby enabling domestic companies and banks to seek out loans from abroad. This action resulted in a deluge of private foreign capital – to the tune of an impressive US $93 billion in the five "problem" countries of East Asia (Indonesia, Malaysia, South Korea, Thailand, and the Philippines) alone in 1996. The rapid inflows led to excessive lending and to bubbles in equity and property markets. The following year, however, the massive inflows became a US $12 billion outflow as investor panic set in. All told, the one-year shift in investor sentiment of US $105 billion amounted to a full 11% of these five countries’ combined GDP.

The flight of foreign capital that precipitated the Asian crisis, the currency collapses that have occurred there, and the ensuing economic dislocations in emerging and other economies have reminded the world of the potentially dangerous consequences of open capital accounts. In the wake of developments in Asia, Russia and Latin America, calls have gone out for measures to guard against the volatile surges of capital that can cripple developing countries and to curb increasingly frequent currency speculation. Are controls on short-term capital flows required to protect economies from this instability and the potential for crises?

1. The Case for Controls

Those who favour the imposition of controls argue that freer capital markets lead to excessive speculative activity and to a "herd mentality" among investors prone to panic during financial crises.⁽⁴⁶⁾ The actions taken by panicky investors in East Asian financial markets affected virtually all the countries with open capital accounts, including those, such as Singapore, whose financial sectors were sound. The flight of short-term capital that has ensued in East Asia has led to a debilitating wave of corporate bankruptcies and economic recession in the region. It is no coincidence that China, which has not engaged in capital account liberalization, has weathered the turbulence in the financial markets much better than many of its neighbours.

Moreover, questions have surfaced regarding the gains from free mobility of capital, given the sizeable costs of the financial crises that inevitably arise. In a recent issue of Foreign Affairs Jagdish Bhagwati, a prominent trade economist from Columbia University, argued that "the claims of enormous benefits from free capital mobility are not persuasive. Substantial gains have been asserted, not demonstrated, and most of the payoff can be obtained by direct equity investment."⁽⁴⁷⁾ That flows of longer-term direct foreign investment are useful for economic growth is not in question; the controversy really surrounds the effectiveness of volatile short-term capital as a tool for economic development.

The point has been made that short-term capital movements, often referred to as "hot money", are not germane to economic development, and should be regulated through the imposition of controls. One country that has done so in the past is Chile. That country had, at least until recently, liberalized its capital account except for capital flows of the volatile, short-term variety. Firms that borrowed abroad had to deposit 30% of the value of the loan in a non-interest-bearing account at the country’s central bank for the duration of one year. Control proponents viewed the Chilean response, effectively a tax on capital inflows, as a prudent form of capital account liberalization. However, it should be noted that the Chilean central bank has now removed the above investment requirement in order to stimulate the very capital inflows that earlier it had been so keen to restrain.⁽⁴⁸⁾

To guard against sudden, massive international bank withdrawals from developing countries experiencing financial difficulties and to help involve private sector investors in the resolution of global financial crises. Canada’s Minister of Finance has called for implementation of a delay mechanism, or "Emergency Standstill Clause(49). Such a tool would impose a temporary freeze on all cross-border financial contracts in the event that the withdrawal of short-term capital was jeopardizing the return of financial stability to the country in question.

Other proposals to adjust the international financial system, designed to overcome the perception that the current system does not adequately allocate private capital to the most appropriate uses, have also been made. In order to help rein in currency speculation, one could also institute the so-called Tobin tax. Named after James Tobin, the economist credited with having been the first to articulate this policy option in 1972, this nominal tax⁽⁵⁰⁾ would be levied on the value of spot transactions in foreign exchange markets. The thinking behind the tax is that it would be of sufficient magnitude to deter excessive currency speculators, but small enough not to hinder genuine investment. No international consensus has emerged on implementing this tax vehicle.

Finally, there is the International Credit Insurance Corporation proposed by the well-known international financier George Soros. This new global agency would guarantee private loans for a fee and up to a certain limit decided upon by officials within the agency⁽⁵¹⁾, but only after receiving from borrowers all the necessary financial information needed for these transactions to be secured. Lenders could provide funds over and above the guaranteed amount, but such loans would be extended at the lending institution’s own risk.

2. The Pitfalls of Controls

On the other side of the debate, most economists argue that widespread capital account liberalization encourages economic efficiency through an improved allocation of savings and investment throughout the world. The free flow of capital, it is claimed, fosters improved economic growth by ensuring access of emerging economies to a huge pool of capital and by increasing potential returns to investors. Even with the sharp reduction in the economic output of the most seriously affected East Asian countries, their economies have only given up, on average, one-sixth of the gains in per capita growth that they had recorded during the past decade.

Notwithstanding the impressive long-term gains, the serious crisis that has arisen in emerging markets has focused a growing number of experts on the need to alter existing financial arrangements. For opponents of control, any drastic moves would be foolhardy. "When domestic financial systems fall for lack of adequate institutional infrastructures, the solution is not to turn back to a less turbulent, but also less prosperous, past regime of capital controls, but to strengthen the domestic institutions that are the prerequisite for engaging in today’s international system."⁽⁵²⁾

At least three specific problem areas are associated with capital controls, or taxes on capital (such as the Tobin tax) for that matter. First, controls on outflows are likely to be circumvented over the long-term, owing to the fact that, unlike inflows, there is a high incentive for investors to find ways to go around them. Similarly, currency trades can be moved to a country not taxing them. It is difficult, for example, to envisage a scenario where all countries would agree to the imposition of a Tobin tax.

Controls may also cause potential investors to bypass the regulating country entirely. Investors are understandably leery of jurisdictions imposing restrictive conditions on their funds. In the case of Malaysia, which in early September erected a fence around its currency and portfolio investment in the hope that its central bank would then be able to push interest rates down below what the international capital markets would otherwise require, analysts are already predicting a noticeable plunge in foreign investment activity. In addition, controls often end up affecting all kinds of private capital inflows, including the long-term foreign direct investment that is essential for growth in developing countries.

Third, the imposition of capital controls can remove the discipline that the international economy brings to domestic policy-making. When policies deemed (by the market) to have been inappropriate have been introduced, capital outflows have served as a trigger for the introduction of useful policy adjustments. Both Thailand and South Korea, for example, have now implemented significant reforms, which have enabled them to reduce their interest rates sharply without causing any currency decline. On the other hand, controls are often viewed as tools used by governments to delay or avoid the reforms that are needed to prevent financial crises in the first place. One can make a strong case that countries such as China have, in the 1990s, avoided reforms that would have promoted stronger financial institutions and higher economic growth.

For the benefits of a free flow of capital to be enjoyed with a much-reduced incidence of the costs, the financial system and overall economic policy-making of emerging-market countries need to be improved. The Asian financial crisis has demonstrated the folly of opening up one’s economy to capital inflows without correspondingly strengthening weak domestic financial sectors, removing the power of governments to allocate credit to favoured borrowers, and freeing up the existing exchange rate regime.

"One of the broad policy issues emerging from the Asian crisis is the appropriate speed with which the capital account should be liberalized in view of the potential for shifts in market sentiment. Successful capital account liberalization requires that certain preconditions be in place and that the process of liberalization be a gradual and orderly one."⁽⁾ Even the IMF now agrees that in certain developing-country situations, it may make sense to impose temporary controls, or retain controls, until such time as the financial system in the country in question is strengthened. As part of his six-point plan to respond to the global financial turbulence, Finance Minister Paul Martin is urging the IMF to develop a practical "roadmap" for safe capital liberalization.

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