Towards a Better Financial Architecture

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Towards a Better FinancialArchitectureStephany Griffith-JonesPublished online: 03 Aug 2010.

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Journal of Human Development, Vol. 1, No. 1, 2000

Towards a Better Financial Architecture*

STEPHANY GRIFFITH-JONESStephany Grif�th-Jones is a Fellow at the Institute of Development Studies,University of Sussex, Brighton BN1 9RE, UK

Introduction

The deep integration of developing countries into the global economy hasmany advantages and positive effects.

In particular, capital �ows to developing countries have clear andimportant bene�ts. The bene�ts are especially clear for foreign directinvestment, which is not only more stable, but also brings technologicalknow-how and access to markets. Other external �ows also have importantpositive microeconomic effects, such as lowering the cost of capital forcredit-worthy �rms. At a macroeconomic level, foreign capital �ows cancomplement domestic savings, leading to higher investment and growth;this latter positive macroeconomic effect is very valuable for low-savingseconomies, but may be less clear for high-savings economies like those ofEast Asia.

However, large surges of short-term and potentially reversible capital�ows to developing countries can also have very negative effects. First,these surges pose complex policy dilemmas for macroeconomic manage-ment, as they can initially push key macroeconomic variables, such asexchange rates and prices of assets like property and shares, away fromwhat could be considered their long-term equilibrium. Second, and moreimportantly, these �ows pose the risk of very sharp reversals. Thesereversals — particularly if they lead to currency and �nancial crises — canresult in very serious losses of output, investment and employment, as wellas dramatic increases in poverty. This has been illustrated dramatically bythe impact of the current crisis in Asia, which has now spread to many othercountries, including most recently Brazil.

Asian-style currency crises — and their extremely high developmentcosts — raise a very serious concern about the net development bene�ts fordeveloping countries of large �ows of potentially reversible short-terminternational capital. While the high costs of reversals of those �ows areevident, the bene�ts are less clear. This is in sharp contrast with foreigndirect investment and trade �ows, where the very large developmental

* This paper was presented at the First Global Forum on Human Development at UNDP, New York on the31 July 1999. It builds on a paper prepared for the 1999 Human Development Report and also draws onjoint work with Jose Antonio Ocampo.

ISSN 0973-1234 print; 1469-9516 online/00/010107-38 Ó 2000 Taylor & Francis Ltd 107

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bene�ts clearly outweigh the costs. As a result, volatile short-term capital�ows emerge as a potential Achilles’ heel for the globalized economy andfor the market economy in developing countries. If the international com-munity and national authorities do not learn to manage these �ows better,there is a serious risk that such volatile �ows could undermine the tremen-dous bene�ts that globalization and free markets can otherwise bring.

The current functioning of the international �nancial system is clearlyunsatisfactory, particularly because it leads to recurrent �nancial crisis, withvery high development costs especially implying increases in poverty fordeveloping countries. It thus risks undermining the development achieve-ments of the otherwise broadly successful market reforms. As a result of theAsian crisis, which spread to other emerging markets, a broad consensus hasemerged on the need and the urgency for reforming the international�nancial system. Although quite important progress has been made, there is,however, lack of agreement and precision in proposals on the exact natureof the changes required. This paper aims to contribute to the discussion, bymaking more precise and comprehensive proposals, both for country pre-vention and for better crisis management.

The next section looks at improved transparency and information ondeveloping countries as one way to deal with currency crises; however, thelimits of this approach are also analyzed, as well as the need for improvedtransparency on international �nancial markets. The third section deals withbetter regulation. It examines the need to �ll global regulatory gaps, as wellas discussing the recently created Forum for Financial Stability. The fourthsection deals with the appropriate scale, timeliness, modalities and condi-tionality in the provision of of�cial liquidity in times of crisis, including adiscussion of the recently created Contingency Credit Line. The penultimatesection deals with involving the private sector, both in crisis prevention —for example, via private contingency credit — as well as in crisis manage-ment — for example, via amendment of bond clauses or via standstillarrangements. The �nal section concludes.

Cr isis prevention : improved transparency and in formation

Actions taken

One of the areas de�ned initially by the G7 countries and the InternationalMonetary Fund (IMF) as central for future crisis avoidance was enhancingtransparency and disclosure of timely and reliable information, basically ondeveloping countries, so as to make it available to market actors. Theassumption was that insuf�cient information had contributed signi�cantly tothe Asian crisis (for a critique of this assumption, see later).

A �urry of activity in improving information followed, as re�ected inthe fact that the �rst of the three working groups of the G22 (whichincluded G7 countries and a range of emerging economies) was devoted toEnhancing Transparency and Disclosure of Information. Among some of thekey signi�cant data gaps and de�ciencies identi�ed were: (1) information on

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Better Financial Architecture

foreign exchange reserves, including undisclosed forward positions, and anyother claims against them; (2) maturity and currency exposures of thepublic and private sectors; and (3) the health of the �nancial system,including information on non-performing loans.

A number of steps have already been taken, of which the main ones arePublic Information Notices (PINs) by countries and strengthening by theIMF of the Special Data Dissemination Standard (SDSS). (For details of theseand some of the other main measures of progress on transparency andstandards, please see Appendix 1.)The PINs are prepared yearly by allcountries after their Article IV consultation with the IMF, and countriesare encouraged to release them speedily. The IMF has also started a pilotprogramme for voluntary release of Article IV staff reports. Of particularimportance has been the strengthening, in the areas of internationalreserves and external debt, of the SDSS, the information standard thatthe IMF had already established in 1996, after the Mexican pesocrisis. Particularly signi�cant is that these will incorporate full detailson reserves, and any claims against them (for all countries), from April1999.

Besides information standards, a number of other standards are beingde�ned (by the IMF and the Bank for International Settlements (BIS), incollaboration with institutions like the World Bank and the Organizationfor Economic Co-operation and Development (OECD)) that are meant toprovide codes of good practice for economic, �nancial and business activi-ties. The IMF will help in the dissemination of these standards and themonitoring of their implementation, by different measures including havingthem as conditions for IMF lending. These standards will include creatingCodes of Good Practices on Fiscal Transparency, and in monetary and�nancial policies, improving the quality of banking supervision, as well asdeveloping standards relevant for the functioning of �nancial systems,including accounting and auditing, bankruptcy, corporate governance, in-surance regulations, payment and settlement systems, and securities’ marketregulations.

Although many of these standards and their implementation may havevery positive effects, e.g. on strengthening �nancial systems, three ratherserious concerns need to be raised and addressed. First, is the de�nition of‘desirable standards’ suf�ciently participatory, i.e. do developing countriesthat will be asked to implement these standards in their own economieshave enough participation in the de�nition of these standards? Shoulddeveloping countries just be encouraged to adopt these standards, ratherthan them being part of IMF conditionality? These concerns could besummarized in the phrase “No standardisation without participation” (Ithank Gerry Helleiner for this point). Second, will implementing thesestandards be really effective in signi�cantly improving the resilience ofdeveloping countries for avoiding crises, and making them less acute if theydo happen? Third, will implementing these standards not impose excessiveadministrative and other burdens on developing country governments,especially the poorer ones, which have more limited resources and exper-

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tise? To help deal with the third problem, appropriate technical assistance— particularly for the poorer countries — is essential.

Limits of this approach, due to inherent problems of asymmetries ofinformation

Clearly, improved information, along the lines of the changes alreadydescribed, will be welcome and useful, contributing to a better marketperformance. However, improved information on developing countries willnot by itself avert crises. First, information available to �nancial markets willnever be perfect and information asymmetries will always exist. Second, itis not clear that better information will be suf�cient for �nancial markets tofunction well, as the key issue is how information is processed and actedupon. Phenomena such as euphoria and herding (see, for example, Grif�th-Jones, 1998) imply that ‘bad news’ are ignored in periods of ‘boom’ andmagni�ed in periods of ‘bust’, with the reverse being true for ‘good news’.Third, better information on developing countries has to be complementedby equally important improved information on international �nancial mar-kets.

As regards the �rst point, there is both clear theoretical analysis andpractical experience which shows that information will always be imper-fect, and that this may cause or contribute to �nancial crises. A clearforerunner of much of the imperfect information literature was Keynes(1936), who in Chapter 12 of the General Theory stressed “the extremeprecariousness of the basis of knowledge on which our estimates ofprospective yields have to be made”. The seminal contributions in modernanalysis of asymmetries of information and their particular signi�cance for�nancial markets have come from Stiglitz (Stiglitz and Weiss, 1981). Mostrecently, Eichengreen (1999) has rather strongly summarized the limits ofimproved information for crises prevention: relying excessively on im-proved transparency “underestimates the extent to which informationasymmetries are intrinsic to �nancial markets … It is unavoidable thatborrowers should know more than lenders about how they plan to useborrowed funds. This reality is a key reason why banks exist in marketeconomies … Bank fragility is inevitable. The advocates of information-re-lated initiatives mislead when they assume the problem away”.

Indeed, sophisticated and increasingly informed �nancial markets havecontinued to be extremely (and even increasingly) volatile. This has oc-curred even in some of the most developed economies in the world, whereserious problems and even crises have occurred in their banking systems,even though they had the highest ratings on transparency, as illustrated bythe banking crises in Scandinavian countries (Bhattacharya and Miller, 1999;Stiglitz and Bhattacharya, 1999).

One very important reason for imperfect information is the fact thatmuch of the relevant information to which the market reacts comes onlywith a lag, and depends on macroeconomic conditions not entirely knownin advance (even though the changes in macroeconomic conditions may be

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determined partly or largely by the aggregate effects of the behaviour of�nancial agents). For example, some of the lending or investment decisionsmade in East Asia before the 1997 crisis may have been unsound, but themagnitude of the losses associated with them were even more determinedby the major macroeconomic shocks that these regions experienced, whoselarge magnitude was probably unpredictable, and, indeed, these shockswere largely unpredicted. Increasing information that may thus be relevantto improve microeconomic market ef�ciency may do little to reducemacroeconomic volatility (Ocampo, 1999). Particularly as regards macro-economic information, markets are necessarily imperfect when time isinvolved, as the information necessary to correct such ‘market imperfec-tions’ will never be fully available.

Second, there are problems as regards the processing of information. Asalready pointed out, the key issue is that increasingly investors (and lenders)are concerned not with what an investment is really worth to a person whobuys it for keeps, but with what the market will value it at in a few hoursor days. The concept behind this was perhaps best captured by Keynes’‘beauty contest’, in which each actor tries to interpret what the averageopinion in the market is. To the extent that this is true, available informationon developing countries will be less important than how the average of themarket is likely to perceive it. The inter-relation of the ‘information’ that�nancial actors manage at any particular time — or rather, of the opinionsand expectations that are formed from such information — is central to therich contemporary literature on self-ful�lling booms and busts.

Microeconomic factors, on how �nancial �rms and banks operate,reinforce such problems. This may be related both to costs and to �rmorganization. A board of a �nancial institution deciding to invest or lend toa particular country may not be able (or willing) to take account of the richinformation available in the research departments of that institution.1

Smaller banks, with small research departments, tend to rely even less ontheir internal expertise, and follow even more decisions of other banks. Asa result, changes in the opinions of those investors that are considered to be‘informed’ may lead to over-reactions by non-informed ones, who rely onthe formers’ lead to make their decisions (Calvo, 1998).

A key problem is that changes in opinion can occur without anysigni�cant change of underlying fundamentals; this occurs because basicallythe same information about a country may be interpreted totally differentlyat different times, due to factors such as the ‘mood of the markets’, eventsin other economies, etc. Also, ‘small news’ that do not alter fundamentalsmay affect market perceptions dramatically. The importance of ‘small news’and its potential impact on changes in market perceptions is magni�ed in aworld of dramatically improved communications and 24-hour trading.

Some concern has even been expressed that, in some cases, infor-mation disclosure could lead to more, and not less, variability in the priceof an asset (Stiglitz and Bhattacharya, 1999). Lack of information may serveto ‘average’ good and bad news; as a consequence, it could even be thecase that improved capabilities of processing and transmitting certain

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information could increase volatility. However, empirical evidence on this isinconclusive, and further research is required.

Overall, we can conclude that, although on the whole very helpful andimportant, improved information on developing countries will by itself benecessary but clearly not suf�cient to prevent future crises, and that farstronger actions are required. This is increasingly — although slowly —being recognized by the international community. A third problem is that,as already pointed out, better information on developing countries has to becomplemented by better information on international �nancial marketsavailable to policy-makers.

Providing additional information on markets to developingcountries

Indeed, particularly during the crisis that started in Asia, emerging countrypolicy-makers (and speci�cally emerging country Central Banks) have foundimportant limitations in the essential information available on the function-ing of international capital and banking markets (unpublished interviewmaterial and own experience). The type of information required is both onmore long-term structural changes in these markets and, particularly, onalmost day to day changes in the functioning of markets — and their keyactors — globally and regionally.

In the same way that the IMF has led the way in improving information— and its dissemination — on emerging market economies, particularlyuseful to markets, a parallel symmetric effort needs to be made to gather andprovide timely information on market evolution to emerging market policy-makers; this task should perhaps be led by the BIS, and coordinated by thenewly created Forum for Financial Stability, although inputs from otherinstitutions, e.g. the IMF, the private sector (for example, the Institute ofInternational Finance), would be very valuable. Although possibly not givingit suf�cient emphasis, suggestions in the October 1998 G22 Report of theWorking Group on Transparency and Accountability did provide importantelements for this task. These suggestions relate not just to better statistics oninternational banks’ exposures, but also on “compiling data on internationalexposures of investment banks, hedge funds and other institutional in-vestors”; the latter would include presumably pension funds and mutualfunds. Furthermore, the growth of �nancial innovations, such as over-the-counter derivatives, while designed to facilitate the transfer of market riskand therefore enhance �nancial stability, have also made �nancial marketsmore complex and opaque. This has created dif�culties in monitoringpatterns of activity in these markets and the distribution of risks in theglobal �nancial system for regulators, central banks, market participants andother authorities, particularly including those in developing countries.

In response to this situation, the Euro-Currency Committee at the BIShas drawn up a framework for the regular collection of statistics onover-the-counter derivatives markets on the basis of reporting by leadingmarket participants. Such efforts to improve transparency, particularly in

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relation to derivatives, and on highly leveraged institutions (such as hedgefunds), are widely welcomed. However, this sector is constantly evolvingand there is a concern that regulatory reporting will never be able to keeppace with this complex and dynamic market. Dif�culties are made greaterby the fact that there are already many gaps in reporting derivatives andactivities of institutions like hedge funds; it would seem appropriate formajor Central Banks and the BIS to attempt to improve registration ofderivatives and institutions like hedge funds, by making it obligatory (unpub-lished interview material). It seems essential that developing countries —including representatives from the poorer countries — should participate inthe relevant Working Groups where information needs are discussed anddecided, so that their information needs on markets are also fully con-sidered.

Given the speed with which markets move, it seems particularlyimportant that the frequency with which relevant data is produced is veryhigh (and possibly higher in times of market turbulence, when it becomesparticularly crucial), and that dissemination is instant to all countries’Central Banks. Indeed, a special additional service could be provided by theBIS, in which it would play the role of clearing house of information. Forthis purpose, it could draw not just on information it can gather directlyfrom markets, but by collecting and centralizing information on the marketsthat individual Central Banks have, and where the aggregate picture is noteasily available to any individual Central Bank. This could possibly includeboth quantitative and qualitative information. Via the internet, the BIS couldstandardize the information requirements, collect the information, aggregateit and disseminate it rapidly to all central banks, as well as to other relevantinstitutions. Such a service would be of the greatest usefulness to develop-ing country policy-makers, especially immediately before and during crises;however, it would naturally also be very valuable to developed countrypolicy-makers and international institutions (including the BIS itself) in hand-ling crisis prevention and management (Grif�th-Jones and Kimmis, 1999).

To summarize, crucial information on capital and banking marketsavailable to policy-makers, particularly in least-developed countries (LDCs) isclearly insuf�cient, especially just before and during currency crises.

The BIS (and the Forum for Financial Stability) seem well placed tobuild on the useful information they already provide, and their network oflinks with central banks, securities’ regulators and markets by expanding itin two directions: (i) broadening coverage, for example, to include moreinformation on institutional investors and in rapidly growing instruments,such as derivatives; and (ii) increasing signi�cantly frequency of information,to provide timely inputs to policy-makers on rapid changes in banking and�nancial markets’ trends.

This exercise would be in some ways symmetrical to the effortsbeing led by the IMF to improve information available on developingcountries, mainly of use to markets; the proposed activity would improveinformation on markets, mainly for the use of country and internationalpolicy-makers.

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If approved, a meeting or a set of meetings, including representativesfrom LDCs, working with BIS staff or the appropriate BIS Committees,seems appropriate for effective implementation. Representatives of LDCs’Central Bank could, for example, appropriately present initial ideas ondesirable additional information, especially from a developing country per-spective, that the BIS (or more broadly the Forum for Financial Stability)could provide, its frequency, etc. The feasibility and value of such additionalinformation could then be explored.

Better r egulations, nationally and internationally

National regulations2

The experience of developing countries at different levels of developmentindicate that the management of capital account volatility requires: (a)consistent and �exible macroeconomic management; (b) strong prudentialregulation and supervision of domestic �nancial systems; and (c) equallystrong ‘liability policies’, aimed at inducing good debt pro�les, public andprivate, domestic and external. Moreover, despite the traditional emphasison crisis management, the focus of authorities should rather be the manage-ment of booms, since it is in the periods of euphoria from capital in�owsand trade expansion, and terms of trade improvement that crises areincubated. Crisis prevention is thus, essentially, an issue of adequate man-agement of boom periods.

Regulation of capital in�ows may also be essential to avoid unsustain-able appreciation of the exchange rate during booms, particularly in the faceof improved terms of trade in commodity-exporting countries. Some appre-ciation may be inevitable and even an ef�cient way to absorb the increasedsupply of foreign exchange, but an excessive revaluation may also generateirreversible ‘Dutch disease’ effects. Regulations of capital in�ows thus playan essential role in open developing economies as a mechanism to allowmonetary and domestic credit restraint, as well as to avoid unsustainableexchange rate appreciation during booms. The macroeconomic role ofregulation of in�ows has, unfortunately, received much less attention indiscussions than the issue of regulation on out�ows during crises; they are,however, more important, as they are associated with the essential issue ofcrisis prevention.

The experience of many countries indicates that strong domesticprudential regulation and supervision are essential to avoid costly �nancialcrises. The experience of both developing and industrialized countriesindicates that �nancial crises are, indeed, very costly, both �scally and interms of economic activity, particularly if they are mixed with currencycrises (the so-called ‘twin’ crises) (see, in particular, International MonetaryFund, 1998, Chapter IV). Given the role of the domestic �nancial system inthe intermediation of external lending, prudential regulation and supervisionalso play an essential role in managing the risks associated with capitalaccount booms.

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The essential role of domestic �nancial regulation and supervision is toguarantee the solvency of domestic �nancial intermediaries, by guaranteeingcapital requirements adequate to the risks that �nancial intermediaries face,avoiding excessive risk taking, including an excessive concentration of risks,and requiring that loan losses are adequately accounted for. However, it hasbecome increasingly clear that in the face of �nancial volatility, domestic�nancial regulation and supervision should also guarantee an adequateliquidity of �nancial intermediaries, as the link between liquidity andsolvency problems are stronger than traditionally perceived. Thus, avoidingsigni�cant mismatches between the term structure of assets and liabilities,and establishing higher reserve or liquidity requirements for the short-termliabilities of the domestic �nancial system also play an essential role indomestic �nancial management.

Prudential regulation and supervision must take into account not onlythe microeconomic, but also the macroeconomic risks typical of developingcountries. In particular, due account should be taken of the links betweendomestic �nancial risk and changes in key macroeconomic policy instru-ments, notably exchange and interest rates. The risks associated with therapid growth of domestic credit, to currency mismatches between assetsand liabilities, to the accumulation of short-term liabilities in foreign curren-cies by �nancial intermediaries and to the valuation of �xed assets used ascollateral during episodes of asset in�ation must be adequately taken intoaccount. Moreover, given these macroeconomic links, prudential regulationsshould be stricter in developing countries, and should be strengthenedduring years of �nancial euphoria or terms of trade improvements to takeinto account the increasing risks which �nancial intermediaries are incur-ring. These links also imply that contractionary monetary or credit policiesduring booms, particularly higher reserve or liquidity requirements andceilings on the growth of domestic credit, may be strongly complementaryto stricter prudential regulation and supervision; indeed, this would implycounter-cyclical elements in both monetary and regulatory policies aredesirable for small economies, subject to large trade or capital accountshocks.

In the case of the public sector, direct controls by the Ministry ofFinance are the adequate instrument of a liability policy. More indirect toolsare necessary to induce a better private debt pro�le. Again, direct exchangecontrols may be the appropriate instrument. An interesting alternative isreserve requirements on capital in�ows, such as those used by Chile andColombia in the early 1990s; indeed, as, in both countries, reserve require-ments can be substituted for a payment to central banks of the opportunitycost of the said requirement, they are in effect a tax on in�ows. A �at taxhas a positive effect on the debt pro�le, as it induces longer-term borrowing,for which the tax can be spread over a longer time frame. This has beengenerally recognized in recent controversies. The effects of this system onthe magnitude of �ows have been subject to a more heated controversy. Inany case, to the extent that elusion is costly, and that short- and long-termborrowing are not perfect substitutes, the magnitude of �ows is also

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affected (Agosin, 1998; Ocampo and Tovar, 1998; Agosin and Ffrench-Davis,1999). If this is the case, the system operates both as a ‘liability’ and amacroeconomic policy tool. A basic advantage of this instrument is also thatit is targeted at capital in�ows, and it is thus a preventive policy tool.

Simple rules such as the Chilean–Colombian system can also play a verypositive role. Any such system must also meet an additional requirement: itmust have the adequate institutional backing. A permanent dynamic system,which is strengthened or loosened throughout the business cycles, ispreferable to the alternation of free capital movements during booms andquantitative controls (e.g. prohibitions on out�ows) during crises. Indeed,the latter system may be totally ineffective if improvized during a crisis,simply because the administrative machinery to make it effective is notoperative and thus leads to massive evasion or elusion of controls. Such asystem is also procyclical and leaves aside the most important lesson learnton crisis prevention: avoid overborrowing during booms and thus targetprimarily capital in�ows rather than out�ows.

International measures

Clearly an important part of the responsibility with discouraging excessivereversible in�ows — as well as managing them — lies with the recipientcountries. However, the large scale of international funds — compared withthe small size of developing country markets — leads us to questionwhether measures to discourage excessive short-term capital in�ows byrecipient countries are enough to deal with capital surges and the risk oftheir reversal. Three strong reasons make complementary action by sourcecountries and internationally necessary. First, not all major recipient coun-tries will be willing to discourage short-term capital in�ows, and some mayeven encourage them. Thus, the tax and regulatory measures taken, forexample, to encourage the Bangkok International Banking Facility, encour-aged short-term borrowing. Second, even those recipient countries thathave deployed a battery of measures to discourage short-term capital in�owshave, on occasions, found these measures insuf�cient to stem very massivein�ows. Third, if major emerging countries experience attacks on theircurrencies, which also result in dif�culties to service their debt, they will beforced to seek large of�cial funding. As a consequence, there is a clear needfor international and/or source country regulation that will discourageexcessive reversible capital in�ows. If this is not developed, internationalprivate investors and creditors might continue to assume excessive risks, inthe knowledge that they will be bailed out if the situation becomes critical.This is the classical moral hazard problem.

The Asian crisis — and its repercussions worldwide — clearlydemonstrated that it is necessary to strengthen source country regulations,coordinate them globally and �ll important regulatory gaps.

The crisis also provoked a serious debate on how supervision andregulation of the international �nancial system could be strengthened inorder to help prevent economic crises of this sort happening again in the

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future. The debate has partly focused on whether existing arrangementsshould be extended and improved, or whether there is now a need for newinstitutions to cope with the increasingly globalized �nancial system, so asto better achieve the necessary improvement of international �nancialregulation and supervision.

At the more institutionally radical end of the scale, there have beenproposals for the creation of a new international body such as a WorldFinancial Authority (Eatwell and Taylor, 1998) or a Board of Overseersof Major International Institutions and Markets. Such a body wouldhave wide-ranging powers for the oversight of regulation and supervisionglobally.

The other approach has been to develop and build on existing institu-tional arrangements. The virtue of this approach was the greater ease, bothtechnically and especially politically, to move forward on this. Indeed, theForum for Financial Stability, which is described in the following, has beencreated and has started to operate, with impressive speed; this seems one ofthe most positive steps towards a new international �nancial architecture.

Both the Canadian and the British governments put forward proposalsbased on this approach in 1998. In the autumn of 1998, Chancellor GordonBrown and Secretary of State Clare Short proposed a standing committee forglobal �nancial regulation to coordinate the multilateral surveillance ofnational �nancial systems, international capital �ows and global systemicrisk. It was proposed that the committee would bring together the WorldBank, the IMF, the Basle Committee of the BIS and other regulatory bodieson a monthly basis to develop and implement ways to ensure that inter-national standards for �nancial regulation and supervision were put in placeand properly coordinated.

The Financial Stability Forum. In October 1998, the G7 �nance ministersand central bank governors approved this idea in principle and asked HansTietmeyer, then president of the Bundesbank, to develop the UK proposaland more generally consider the cooperation and coordination between thevarious international regulatory and supervisory bodies, and to make recom-mendations for any new arrangements. Tietmeyer’s report, released inFebruary 1999, outlined areas where improvements to current arrangementswere necessary, but stated that “Sweeping institutional changes are notneeded to realise these improvements” (Tietmeyer, 1999). Instead, it wasproposed that a Financial Stability Forum, which would meet regularly todiscuss issues affecting the global �nancial system and to identify actionsneeded to enhance stability, be convened. The Forum was formally en-dorsed by �nance ministers and central bank governors from the G7 at theirFebruary meeting in Bonn, and met for the �rst time in spring 1999.

The Tietmeyer report had correctly outlined three main areas forimprovement to current arrangements that have been highlighted by recentevents in international �nancial markets: (a) identify vulnerabilities in na-tional and international �nancial systems, and sources of systemic risk, andto identify effective policies to mitigate them; (b) ensure that inter-

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national rules and standards of best practice are developed and imple-mented, and that gaps in standards are identi�ed and �lled; and (c) im-proved arrangements are needed to ensure consistent international rules andarrangements across all types of �nancial institutions.

The Financial Stability Forum will be limited in size to 35 members, inorder to allow for an effective exchange of views and decision-making. EachG7 country will have three representatives on the Forum, from the �nanceministry, central bank and supervisory authority. The G7 stated that whilethe Forum will initially be limited to G7 countries, it is envisaged that othernational authorities, including those from emerging market countries, willjoin the process at some stage. The IMF and the World Bank will have tworepresentatives each, as will the Basle Committee on Banking Supervision,the International Organization of Securities Commissions (IOSCO) and theInternational Association of Insurance Supervisors (IAIS). The Bank forInternational Settlements, the OECD and the two BIS Committees will allhave one representative on the Forum.

The Forum will be chaired by Andrew Crockett, general manager of theBIS, for the �rst 3 years and it will have a very small secretariat in Basle. TheForum will initially meet twice a year, beginning in spring 1999. One of thekey aims of the Forum will be to better coordinate the responsibilities of themain national and international authorities, and supervisory bodies, and topool the information held by these various bodies, in order to improve thefunctioning of markets and reduce systemic risk. Subsequent to its meetingin Washington on 14 April, the Financial Stability Forum has de�ned threead hoc working groups, to tackle recommendations on three subjectsde�ned as key.

(a) To recommend actions to reduce the destabilizing potential of institu-tions employing a high degree of leverage (HLIs) in the �nancial marketsof developed and developing economies; this group will be chaired byMr Howard Davies, Chairman of the UK Financial Services.

(b) To evaluate measures in borrower and creditor countries that couldreduce the volatility of capital �ows and the risks to �nancial systems ofexcessive short-term external indebtedness; this group will be chairedby Mr Mario Draghi. Reportedly, among developing countries, Chile andMalaysia will participate.

(c) To evaluate the impact on global �nancial stability of the uses made bymarket participants of �nancial offshore centres, and the progress madeby such centres in enforcing international prudential standards and incomplying with cross-border information exchange agreements. As re-gards offshore centres, reportedly an assessment will be made of theadditional efforts required to avoid under-regulation or inappropriatedisclosure in offshore centres contributing to global �nancial instability.This group will be chaired by Mr John Palmer, Superintendent ofFinancial Institutions.

It is important to stress that the working groups comprise of�cials ofdeveloped and developing market economies, international �nancial institu-

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tions and supervisory groupings, and will draw on work completed or underway in various public and private-sector forums. It is interesting that seniorof�cials from developing countries have been included, where their exper-tise is seen as particularly relevant. For example, the group that will studymeasures to study volatility of capital �ows includes senior representativesfrom Chile and Malaysia, two countries that have implemented measures tocurb in�ows and out�ows (Malaysia for both, and Chile for in�ows).

The setting up of the Financial Stability Forum is clearly a verynecessary and valuable �rst step towards improving the coordination andcooperation of the various bodies that work towards improving the waymarkets work in order to improve global stability. The question lies,however, in whether the Forum, as it has been proposed, will be arepresentative enough and strong enough body to address all these complexissues.

First, the omission of any developing country authorities in the initialyears of the Forum itself appears to be an important error. It has beenincreasingly accepted, especially since the Mexican peso crisis and thecurrent international �nancial crisis, that international �nance is more andmore globalized, that developing countries are important actors in thisglobalized �nancial system, and that currency crises in LDCs pose bothsystemic threats to the international �nancial system and threats to theirdevelopment prospects. The experiences of developing countries will notbe directly represented at the Forum itself. Representation of developingcountries on the Forum would be desirable for both legitimacy reasons andbecause it would provide the body with a wider range of expertise andperspectives. However, the representation of developing countries in the adhoc Working Groups is clearly a positive development.

Ways could easily be found to include developing countries in theForum without making it too large. If three developing countries represen-tatives were included, the membership of the Forum would rise from 35 to38, which is less than 10%. Developing country representatives, fromcountries with large levels of private capital in�ows or who have major�nancial centres, could, for example, be chosen on a regional basis; therecould be one Asian, one Latin American and one African. This would ensurealso that the interests of poorer countries would be represented. Theserepresentatives could be appointed for a fairly short period (e.g. 2 years) andthen rotated. This type of representation by developing countries has beenworking rather well in other contexts, for example in the Boards of theBretton Woods institutions. It has also been suggested (unpublished inter-view material) that not all G7 countries would need to be included if it wasfelt that size needed limiting. For example, all G7 countries that have large�nancial centres could be included as permanent members; other G7countries could be rotated.

The Forum for Financial Stability is a very important initiative, whichhopefully will reduce vulnerabilities in the international �nancial system bypromoting coordination and cooperation among G7 regulators, centralbankers and international �nancial institutions. Adding a small representa-

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tion from developing countries to the Forum would increase those coun-tries’ commitment to its aims, as well as add valuable insights to itsdecision-making process. It would seem to be bene�cial to all involved.

Second, doubts have been voiced over the institutional strength of thenew Financial Stability Forum. With a very small secretariat in Basle (cur-rently it has only three staff members), meeting only twice yearly and nopower of enforcement, will the Forum have the suf�cient institutionalmuscle to deal with the tasks that have been identi�ed? Can its response bespeedy and agile enough to a rapidly changing international private system?The setting up of the Forum represents a signi�cant enhancement of thesystem of global regulation by agreement and peer pressure that has beenshown to work reasonably well in the context of the Basle Committees ofthe BIS (Grif�th-Jones and Kimmis, 1999). International cooperation at theBIS has always been based on home-country control, where sovereigntyremains at the level of the nation state, and agreements are reached throughnegotiation and then implemented, where necessary, through nationallegislation or regulation. Countries which are not represented at the BasleCommittee have also adopted some of their directives (most notably, thecapital adequacy standards). However, in the medium term, in a world ofopen �nancial markets, an international body whose Board meets regularlyand has the power to make and enforce policy may well be needed (Eatwell,1999). This would point towards a body more akin to some kind of WorldFinancial Authority, which would be endowed with executive powers alongthe lines of a World Trade Organization (WTO) for �nance.

In the meantime, however, the Financial Stability Forum is a veryimportant step in the right direction. Time will tell whether this body issuf�cient to promote international �nancial stability, and to �ll the import-ant gaps in �nancial regulation which undermine such stability.

Filling regulatory gaps. There are three categories of �ows and institutionsto emerging markets where additional international and/or source countryregulation and supervision may be particularly necessary, as these �owsseem insuf�ciently regulated and their surges, as well as out�ows, haveplayed a particularly prominent role in sparking off recent currency crisis;the latter would seem to occur particularly because they are reversible. Oneof these are short-term bank loans (particularly important in the Asiancrisis); the second are easily reversible portfolio �ows, made by institutionalinvestors, such as mutual funds (especially important in the Mexican pesocrisis but also important in East Asia); the third are activities by hedge fundsand more generally highly leveraged institutions, relating in particular todifferent types of derivatives.

As already discussed, the Forum for Financial Stability (FSF) will exam-ine, in its Working Groups, issues relating to short-term bank loans and tohighly leveraged institutions. However, it would also be desirable for the FSFto examine issues relating to easily reversible portfolio �ows made byinstitutional investors such as hedge funds.

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Bank loans. International bank loans (including short-term ones) are alreadyregulated by industrial countries’ Central Banks; these national regulationsare co-ordinated by the Basle Committee. However, existing regulationswere not enough to discourage excessive short-term bank lending to severalof the East Asian countries, whose reversal played a major role in triggeringof crises in those countries. A key reason for such high short-term banklending to East Asia was that until just before the crisis, most of these EastAsian countries (and particularly countries like South Korea) were seen byeverybody including regulators as creditworthy. Another important reasonhas been current regulatory practice, which has a bias in favour of short-term lending. For example, for non-OECD countries, loans of residualmaturity of up to 1 year have a weighting of only 20% for capital adequacypurposes, while loans over 1 year have a weighting of 100% for capitaladequacy purposes. This was done to re�ect the fact that is easier forindividual banks to pull out from renewing short-term loans. However, as aresult of this rule, short-term lending is signi�cantly more pro�table forinternational banks. Therefore, added to banks’ economic preference forlending short-term, especially in situations of perceived increased risk, is aperverse regulatory bias that also encourages short-term lending. The initialintention was to protect banks, and their liquidity, by encouraging moreshort-term lending. An overall increase in short-term loans, however, makescountries more vulnerable to currency crises and therefore, paradoxically,banks also more vulnerable, to risk of non-payment of short-term loans.

It is interesting that soon after the Asian crisis (around April 1998),clear proposals emerged (Greenspan, 1998; see also Grif�th-Jones andKimmis, 1998) to increase the capital charge through the assignment of ahigher risk weight to short-term interbank credits than the 20% assignedunder the Basle Capital Accord, so as to reduce the excessive incentivetowards such short-term loans. However, even though this change seemedto have very broad support, progress was not made for 1 year on it as astand-alone proposal (International Monetary Fund, 1999; unpublished inter-view material). Instead, a review on this issue was placed within the contextof a comprehensive reassessment of Basle treatment of credit risk, for whicha special task force was created. Unfortunately, a totally separate issue(linked to the capital adequacy required for mortgages lent by Germanbanks) delayed overall agreement for at least 1 year, on revision of capitaladequacy rules (Financial Times, 14 May 14W1999). Questions need to beraised, therefore, not just on appropriate technical measures to build a newinternational �nancial architecture, but on mechanisms for speeding up theprocess through which decisions — especially those on which there isagreement — can be quickly taken. This should be particularly so for thecase where clear institutional mechanisms are already in place (in this case,the Basle Committee of Bank Supervisors) that should allow rapid decision-making to take place.

Portolio �ows. As regards portfolio �ows to emerging markets, there is animportant regulatory gap, as at present there is no regulatory framework

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internationally for taking account of market or credit risks on �ows originat-ing in institutional investors, such as mutual funds (and more broadly for�ows originating in non-bank institutions). This important regulatory gapneeds to be �lled, both to protect retail investors in developed countries anddeveloping countries from the negative effects of excessively large andpotentially volatile portfolio �ows.

The East Asian crisis con�rms what was particularly clearly visible inthe Mexican peso crisis (Borio, 1998; Grif�th-Jones, 1998). Institutionalinvestors, like mutual funds, given the very liquid nature of their invest-ments, can play an important role in contributing to developing countrycurrency crises. It seems important, therefore, to introduce some regulationto discourage excessive surges of portfolio �ows. This could perhaps bestbe achieved by a variable risk-weighted cash requirement for institutionalinvestors, such as mutual funds. These cash requirements would be placedas interest-bearing deposits in commercial banks. Introducing a dynamicrisk-weighted cash requirement for mutual funds (and perhaps other institu-tional investors) is in the mainstream of current regulatory thinking andwould require that standards be provided by relevant regulatory authoritiesor agreed internationally. The guidelines for macroeconomic risk, whichwould determine the cash requirement, would take into account suchvulnerability variables as the ratio of a country’s current account de�cit (orsurplus) to Gross Domestic Product, the level of its short-term externalliabilities to foreign exchange reserves, the fragility of the banking system,as well as other relevant country risk factors. It is important that quitesophisticated analysis is used, to avoid simplistic criteria stigmatizing coun-tries unnecessarily. The views of the national Central Bank and the Treasuryin the source countries and of the IMF and the BIS should be helpful in thisrespect. The securities regulators in source countries would be the mostappropriate institutions to implement such regulations, which could beco-ordinated internationally by IOSCO, probably best in the context of theForum for Financial Stability.

The fact that the level of required cash reserves would vary with thelevel of countries’ perceived ‘macroeconomic risk’ would make it relativelymore pro�table to invest more in countries with good fundamentals, andrelatively less pro�table to invest in countries with more problematic macroor �nancial sector fundamentals. If these fundamentals in a country woulddeteriorate, investment would decline gradually, which hopefully wouldforce an early correction of policy and a resumption of �ows. Although therequirement for cash reserves on mutual funds’ assets invested in emergingmarkets could increase somewhat the cost of raising foreign capital forthem, this would be compensated by the bene�t of a more stable supply offunds, at a more stable cost. Furthermore, this smoothing of �ows wouldhopefully discourage the massive and sudden reversal of �ows that sparkedoff both the Mexican and the Asian crises, making such developmentallycostly crises less likely.

Given the dominant role and rapid growth of institutional investors incountries such as the US, the UK and France, this proposal — for a

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risk-weighted cash requirement on mutual funds — could possibly beadopted �rst in those countries, without creating signi�cant competitivedisadvantages soon after international harmonization would have to beintroduced. However, an alternative route would be for such measures to bestudied and implemented internationally being discussed initially withinIOSCO, and/or in the broader context of the Forum for Financial Stability.International coordination of such a measure would prevent investments bymutual funds being channelled through different countries, and especiallyoff-shore centres, that did not impose these cash requirements (the latterpoint draws on communication with the Federal Reserve Board).

Such IOSCO international guidelines would be formulated throughinternational consultations similar to those employed by the Basle Com-mittee in developing the ‘Core Principles for Effective Banking Supervision’.The guidelines could be developed by a working group consisting ofrepresentatives of the national securities’ regulatory authorities in sourcecountries together with some representation from developing countries, inthe context of IOSCO. Due account should be taken of relevant existingregulations, such as the European Commission’s Capital Adequacy Directive.

Finally, it is important to stress that additional regulation of mutualfunds should be consistent with regulation of other institutions (e.g. banks)and other potentially volatile �ows.

Highly leveraged institutions. Further urgent study is required to detect andcover any other existing monitoring and/or regulatory gaps, e.g. as relates toinstruments, such as derivatives, and institutions, such as hedge funds.Careful analysis — both technical and institutional — is required on howhedge funds and other highly leveraged institutions can best be regulated toreduce their impact on magnifying volatility of capital �ows, exchange ratesand stock markets in developing countries, and the negative effect that thisvolatility has on development and on poverty. It is encouraging that thereis a growing consensus, as re�ected for example in the January 1999 Reportby the Basle Committee on ‘Banking Supervision, on Banks’ Interactionswith highly leveraged Institutions (HLIs)’, that HLIs can pose important risksboth to direct creditors and, under certain market conditions, to the�nancial system as a whole.

An additional crucial concern — of the impact of HLIs on magnifyingvolatility in developing countries — has not yet been suf�ciently studied andaccepted, nor have measures designed to deal speci�cally with this issuebeen proposed internationally. However, policy responses to address risksposed by HLIs to creditors and the �nancial system as a whole will also helpreduce negative impact on developing countries.

It is, �rstly, important to stress that the problem does not just relate tohedge funds, but to other highly leveraged activities or institutions, such asproprietary desks of investment banks. HLIs can be de�ned as having threecharacteristics: (a) they are subject to little or no regulatory oversight, as asigni�cant proportion operate through offshore centres; (b) they are subject

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to limited disclosure requirements, and often their operations are veryopaque; (c) they take on signi�cant leverage.

There are three sets of responses that can be used to address risksposed by the HLIs. Often, they are presented as alternatives. However, itwould seem better to consider them as complementary. The �rst responseis indirect, through the major counter-parties of HLIs (mainly banks andsecurities houses). This can be done by promoting sounder practices in theway that banks and securities houses assess risks when they deal with hedgefunds and other HLIs. However, further actions by supervisory authoritiesalso seem desirable. In particular, it seems desirable for supervisors toimpose higher capital requirements on lending or other exposures of banksto HLIs, to re�ect the higher risks involved in such exposures, due to HLIsopaqueness, high leverage and the fact they are not regulated. It may alsobe desirable for supervisors to, either formally or informally, prohibit banksfrom lending to a particular class of risky counter-party. Such measures maynot only protect banks, but could also possibly stimulate HLIs to managerisks in a more responsible way.

A second avenue, which is clearly complementary to the �rst, is toincrease transparency on total exposures to HLIs by all �nancial institutions.One possibility would be an extension of the concept of a credit register forbank loans (along the model of the French ‘central des risques’, whichprovides banks access to the aggregate amount of bank lending to eachcompany). Such a register would collect, in a centralized place, totalexposures (both on and off balance-sheet positions) of different �nancialintermediaries to single counter-parties, such as major hedge funds. Counter-parties, supervisors and central banks (both of developed and developingcountries) could then obtain information about total indebtedness of suchinstitutions, which would help them assess risks involved far more precisely.For this purpose, the information would have to be both timely andmeaningful (especially to take account of rapid shifts in HLIs positions). Itwould seem best if such a register would be based at the BIS itself or at theBasle Committee on the Global Financial System (formerly the Euro-Cur-rency Standing Committee), which already has experience in similar infor-mation gathering.

A third avenue is to directly regulate hedge funds and other highlyleveraged institutions. Such direct regulation could take a number offorms, including licensing requirements, minimum capital standards andminimum standards for risk management and control. In its recent report,the Basle Committee on Banking Regulation has argued that such a regula-tory regime should focus on the potential to generate systemic risk by HLIactivities due to their excessive size and risk-taking, which could endanger�nancial stability. However, if as seems probable, HLIs also have additionalnegative effects on increasing volatility of exchange rates in developingcountries, this concern should also be addressed in attempts at theirregulation.

There is, at present, more support for the �rst two forms of dealingwith HLIs and relatively less support for their direct regulation, even though

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though the latter would deal with the problem in a more direct andstraightforward manner.

The opposition to such direct regulation is presented as based onpractical grounds. For example, it is argued that HLIs could restruc-ture themselves so they escape any regulatory de�nition that may exist.However, this problem can be overcome by an appropriate system ofmonitoring and policing; its costs would surely outweigh the bene�ts ofalleviating large potential systemic risks, as well as risks of currency insta-bility in developing countries! The most frequent argument against directregulation of hedge funds is that they would be able to circumvent suchregulations, because these institutions either already are or could moveeasily offshore.

This problem can either be tackled by accepting the absurd existingstatus quo (and incurring continued high costs of risk of major instability)or raising the issue of extending that and other regulation to offshorecentres. Indeed, if global supervision and regulation is genuinely accepted asessential in today’s world of globalized �nancial markets, there can be nojusti�cation for ‘no-go’ areas, where such regulations could be evaded orundermined. Both as regards provision of information and as regards globalregulation of institutions such as hedge funds, it is essential that off-shorecentres comply with international standards. If the G7 countries in particu-lar backed this clearly, and if developing countries supported it, a politicalinitiative in this respect should be both effective and useful.

More generally, further work is required to gain a better understandingof recent changes in global credit and capital markets, and — morespeci�cally — of the criteria used by different categories of market actors —including banks, mutual funds, hedge funds and others — to go in and outof countries, as well as the incentives that encourage particular patterns ofmarket actors’ behaviour which contribute to speculative pressures onindividual countries and to contagion to other countries. A better under-standing of behavioural patterns and of trends in out�ows could help designmeasures — to be taken by individual �rms, by parts of the �nancial industryvia self-regulation, by regulators and/or by governments (e.g. via tax mea-sures) — to discourage market imperfections, like disaster myopia andherding, that contribute to currency crises.

It can be concluded that a package of measures need to be taken tomake currency crises in emerging markets far less likely, and thereforeensure the ef�cient operation of the market economy in emerging markets,which should be a basis for sustained development. The objective of crisesavoidance seems to require some discouragement and/or regulation ofexcessive and potentially unsustainable short-term in�ows. Such measureswould be most effective if they are applied both by source and recipientcountries (although the main responsibility lies with recipient countries), ifthese measures avoid discouraging more long-term �ows — which, on thecontrary, need to be encouraged — if the rules designed are simple andclearly targeted at unsustainable �ows, and, particularly, if they are comple-mented by good policies in the emerging economies.

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Better cr isis management: provision of of� cial liquidity intimes of cr isis

The role of IMF and other institutions in of�cial liquidity provision

The need for liquidity provision in times of crisis is a well-accepted principle.It may be called the principle of the ‘emergency �nancier’, to differentiate itfrom the role that a central bank plays at the national level as a ‘lender of lastresort’, which is not exactly matched by the IMF. Particularly, the Fundprovides exceptional lending but certainly not liquidity,3 a fact that isre�ected in the lack of automaticity in the availability of �nancing duringcrises. Such emergency �nancing role has led, as we saw in the secondsection, to the provision of anti-cyclical lending by the IMF, matched in somemajor ‘rescue packages’ by bilateral �nancing from major countries, inaddition to their contribution to the IMF’s agreements to borrow. Some majoradvances during the recent international �nancial crises were the signi�cantincrease in IMF resources through: (a) a new quota increase and the NewArrangements to Borrow, �nally effective in 1998; (b) the launching ofthe new window in December 1997, to �nance exceptional borrowingrequirements during crises; and (c) the creation of the Contingency CreditLine (CCL) in April 1999 to provide �nancing to countries facing contagion.The CCL is analyzed in more detail in the following.

Timing of provision of of�cial liquidity, the new contingency creditlines

The CCL has responded to the strong demand for the IMF to leave aside theprinciples of ‘fundamental disequilibrium’ of the balance of payments, onwhich it was built, to �nance countries in dif�culties before and not afterinternational reserves are depleted. This is an essential requirement in theera of rapid capital out�ows that can destabilize economies in a matter ofdays, a lesson that the international community learnt during the Mexican,Asian and post-Asian shocks. It is also, above all, a response to the requestfor new credit lines to �nance countries facing contagion. Although thisproblem is certainly not new, it has reached unprecedented levels in thecurrent decade, which led �nally to a strong request for support tocountries facing contagion.

The CCL has been widely perceived as a signi�cant move from the IMFin the area of crisis prevention for countries that are victims of contagion.The facility was implemented by the IMF in April 1999 as part of its ongoingwork on strengthening the architecture of the international �nancial systemand as a response to the increased need for liquidity provision for crisisprevention. The facility is a “precautionary line of defence readily availableagainst future balance of payments problems that might arise from inter-national �nancial contagion” (International Monetary Fund, 1999). To qual-ify, the increased pressure on the recipient country’s capital account andinternational reserves must thus result from a sudden loss of con�denceamong investors triggered by external factors.

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Early provision of liquidity should help reduce external constraints ondomestic monetary policy, increasing the level of reserves available forcurrency defence and relaxing the constraints on interest rates. It is thus avery important and positive step further as it should, in principle, reduce thechances of entering into a crisis.

The CCL differs from the Supplementary Reserve Facility (SRF) mainlybecause of the timing of disbursement.4 Indeed, the SRF is designed forcountries already facing a �nancial crisis, whereas the CCL is triggered earlyon, in a precautionary manner, for countries not facing a crisis at the timeof commitment, but rather fearing to be affected by contagion. The cost ofthe credit line, 300 basis points above the rate of charge on regular IMFdrawings with a penalty of 50 basis points every 6 months, has been set upto reduce moral hazard on the debtor side and is the same as for the SRF.It should prevent countries from drawing on the line in ‘good’ times.

The CCL’s crucial aim is thus to reduce the chances of countries to becaught by contagion. Its way of functioning, to give leverage of conditional-ity to the IMF early on, is such that, ideally, countries should not suffer fromcontagion and thus need not draw on the line. Put differently, the CCLprovides a strong incentive for countries to make sound policy choices thatprovide a stable economic and �nancial environment. The facility works asa two-stage process, very much like an option that is bought in ‘normaltimes’. Its cost is the country’s compliance with four sets of criteria.

· Adoption of strong policies. Member countries should have implementeda combination of policies that provide a stable economic environmentsuch that, in the absence of contagion, no IMF �nancing should berequired. Economic stability together with �nancial sustainability shouldbe evident. Special attention is paid to an economic and �nancial pro-gramme to be implemented within the period of examination.

· Macroeconomic performance. The article IV consultation is used as abenchmark for economic performance. An ongoing assessment of thecountry is also carried out once the consultation is over. This monitoringis used to assess the countries’ willingness to — and effectiveness in —adopting policy suggestions.

· Advances in adhering to internationally accepted standards. This is anarea which is still evolving as some standards have not yet been �nalized(notably, the codes of transparency in monetary and �nancial policy).Other standards include the subscription to SDDS, the Basle Core princi-ples for bank supervision and the code of transparency of �scal policy(see earlier). Countries need not necessarily meet all the standards, butshould prove some progress in adhering to them.

· Relation with the private sector. The IMF stresses the importance of‘constructive’ relations with private creditors. These relations encompassmanagement of external debt (limiting external vulnerability) and anumber of arrangements with private creditors. Examples of arrange-ments given by the Fund include private-sector CCL, call options in debt

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instruments (allowing debtors to extend maturities), a modi�cation ofbond covenants (see section on involving the private sector later) anddomestic bankruptcy laws.

The monitoring of external vulnerability through indicators of sustain-ability such as the level of international reserves, the ratio of short-termexternal debt in relation to reserves, and the exchange rate regime are alsoconditions. These conditions should help prevent Asian style crises in thefuture and are therefore very positive.

Once the presented criteria are met and the CCL agreed, the countrycan exercise the option at any time but with one further restriction. An‘expeditious’ consultation is carried out by the Board to verify if the countryis still eligible, before funds are disbursed.

However, the new credit line raises a number of issues, a least in �veareas. First, the question of the scale of liquidity provision. Formally, the sizeof the CCL is unlimited. This is imperative, as very large amounts of liquiditymight be required in times of major loss of con�dence. The rationale of thisargument is based on Bagehot’s rules, namely that, to perform well in acrisis, a Lender of Last Resort should lend quickly, freely and readily.However, in practice, because of �nancial constraints, the Fund has dis-closed a range of disbursement from 300 to 500% of member nation’s IMFquota.5 This limitation is problematic, as in a crisis, it is the unlimited natureof contingency �nancing which is crucial. A limited facility could, in certaincircumstances, accelerate out�ows, as creditors ‘rush for the door’ for fearit may close, if revenues run out.

Estimates from April 1999, based on the upper ceiling of 500% of quota,evaluate the CCL to be of an order of $20 billion for Brazil, $11 billion forKorea and $7.4 billion for Thailand. Non-affected countries like Argentinawould receive up to $14 billion, Chile $5.8 billion, Mexico $17 billion,Hungary $7 billion and South Africa $12 billion (Davitte, 1999; Chote, 1999).These amounts appear quite low and could turn out to be insuf�cient tofully absorb external shocks. For example, Brazil, which accessed a �nancialpackage in some ways similar to the CCL but before its formal implemen-tation, received more than twice the amount it is eligible for at present.

At the time of writing, no country had of�cially declared applying tothe scheme, although some policy-makers had expressed their opinions onit. Mexican of�cials, for example, fear not to be eligible due to their currentinvolvement with the IMF through a stand-by loan facility. Others haveunderlined the paradoxical situation of ‘good’ countries not willing to belabelled with the CCL, while countries in potential dif�culty �nd it very hardto comply with too stringent conditions.

Second, the special ‘activation’ review by the IMF Board — as the CCLis today structured — does not look necessary. Indeed, the eligibilityconditions have been designed so that the CCL is drawn as rarely aspossible. As a matter of fact, the implementation of strong macro policiesand the adherence to international standards, together with the building upof sound relationships with private creditors, should, by themselves, protect

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countries from �nancial crisis triggered by the deterioration of domesticfactors. If a given country complies with these criteria, then the onlypossible reason why it could face a �nancial crisis is because of contagion.

Furthermore, the automatic triggering is critical to the good functioningof the CCL, as it would give instantaneous access to new liquidity. Indeed,as seen recently in several cases, a loss of con�dence can have majorimpacts in a very short period of time. A few hours or days might then havea determinant impact on the outcome of the crisis. The approval requiredby the Board, even if it were expeditious, would still not be fast enough andcould allow large out�ows of funds.

The automatic disbursement, if implemented, could be associated witha shorter repayment period, possibly 6 months. Countries that experiencedliquidity crisis in the past usually required fairly large amounts of liquidity,extremely rapidly but for a brief period.

Third, it is still not very clear what will be the potential signalling effecton private investors of countries applying for the CCL but failing to meet thecriteria or of countries loosing their access to it. A certain degree ofcon�dentiality could possibly dampen this effect. For example, informationcould only be disclosed on countries that have been accepted but not onthose applying for it.

Fourth, as already mentioned, the facility is not open to countries withcurrent or expected regular IMF �nancing. It could thus eliminate access tothis type of �nancing to countries which are in a strong process of recoveryfrom a past crisis but still have pending IMF credits.

Fifth, although the conditions de�ned by the IMF for pre-quali�cationshould on the whole help avoid crises, there is a danger that some policyactions, speci�cally targeted at strengthening investors con�dence, mightdiscourage rapid growth. And �nally, there could be the risk that countriesreceiving a CCL would have in�ows that are too large, due to excessivecon�dence from private investors.

Therefore, in practice, despite signi�cant advance, the approved creditlines will continue to lack the full stabilizing effects that are expected fromIMF interventions during crisis, as the negotiation process will continue tobe cumbersome and funds may not be available to all countries that requirethem at the appropriate time and in adequate quantities. Equally important,funds available to the IMF for exceptional �nancing will continue to be shortof the amounts required, as the experience of the 1990s indicates. This isobviously a crucial issue, as stabilizing effects will continue to be absent tothe extent that the market judges that the intervening authorities are unableor unwilling to supply funds in the quantities required to stabilize specula-tive pressures. Moreover, under these conditions, national authorities maybe forced to over-react, adopting a pro-cyclical stance, in an effort togenerate con�dence in private markets. For the world economy as a whole,this would be re�ected in enhanced de�ationary biases.

Well-funded IMF contingency �nancing is obviously the sine qua nonof any reform effort. As bilateral �nancing and contributions to the IMFwill continue to be scarce, the best solution could possibly be to allow

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additional issues of SDRs (Special Drawing Rights) under critical �nancialconditions, to create the additional liquidity required (United Nations TaskForce, 1999a). These funds could be destroyed once �nancial conditionsnormalize. This procedure would also create an anti-cyclical element inworld liquidity management and would give SDRs an increasing role inworld �nance, a principle that developing countries advocated in the pastand should continue to do so. Although technically very attractive, thisproposal may face signi�cant opposition, particularly as several of the majorcountries have been opposed to any issues of SDRs at all, which has impliedthat no issues have taken place for a very long time. A second-bestalternative would be to allow the IMF to raise, in the market, the resourcesneeded to adequately fund contingency �nancing or to rely on Central Bankswap arrangements, arranged either by the IMF or the BIS.

The role of pr ivate sector involvement in preventing andresolving cr ises

A number of proposals have been put forward for ex ante measures directlyinvolving the private sector, to be designed and put in place before crisesoccur (for a very useful recent overview of such measures, see IMF (1999)).These would not only help diminish severity of crises should they occur, butalso (for example, by improving the pricing of risk) diminish the likelihoodof crises occurring.

Measures involving the private sector can: (a) help limit moral hazard,which arises when lenders and investors are repeatedly bailed out; (b) implyfairer burden-sharing between the of�cial and private sector, should crisesoccur; and (c) most importantly, contribute to fairer burden-sharing be-tween capital-recipient countries and their creditors and investors. Indeed,the standard crisis response in situations like East Asia — where creditorsand investors suffer only fairly limited losses, and the people of thecapital-recipient countries see their country’s growth undermined and sufferlarge increases in unemployment and poverty — clearly needs modifying.

However, measures to involve the private sector (particularly in bur-den-sharing) need to be carefully designed, so as to avoid excessivelydiscouraging desirable private �ows to emerging markets, or too sharpincreases in their cost. The views of developing countries therefore need tobe considered carefully.

In the following, we will review some of the main measures underdiscussion, brie�y evaluating their costs and bene�ts.

Contingent �nancing arrangements from commercial banks

At the heart of currency and �nancial crises is the issue of provision ofsuf�cient liquidity in times of distress, particularly for countries that arepotentially creditworthy in the long term. Indeed, if suf�cient liquidity is notprovided in a timely fashion, there is a risk that liquidity crises can be turned

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into solvency problems, which increases the costs to all involved, andparticularly to debtor countries.

An important reason for contingent �nancing arrangements is theexistence of multiple equilibria (Stiglitz and Bhattacharya, 1999). Individuallenders and investors, who believe that others are going to withdraw theirmoney, do so for that reason. The provision of temporary funds can limit aliquidity crisis, and stop it becoming a solvency crisis. Even better, the beliefthat there are funds available eliminates the incentive to pull out; as a result,the liquidity crisis can be avoided.

We have already discussed contingent �nance provided by the IMF andother of�cial bodies, and, in particular, the recently created CCL. It seemsimportant that such of�cial facilities are complemented by private contin-gent credit lines. Indeed, one of the possible pre-conditions for an IMF CCLis for the country to have “in place, or be putting in place, contingentprivate credit lines or similar arrangements” (‘IMF Summing Up’ by Chair-man of Executive Board Meeting 99/48, available on www.imf.org).

An important operational issue is how private-IMF credit levels wouldbe coordinated if a CCL is approved. One possibility would be for the IMFto approve a CCL in broad terms, for private �nancing then to be sought,and for levels of contingent IMF credit to be �nalized afterwards. Althoughthis could reduce the scale of IMF lending, and improve burden-sharing,between the of�cial and private sector, it could have the problem ofindeterminancy. Therefore, it may be easier for countries to arrange, forexample, a full CCL �rst (including the actual levels of contingency lending)and then approach the private sector for complementary contingencylending.

It is interesting that Argentina, Indonesia and Mexico have alreadyarranged such lines of credit with private banks, to be drawn upon in theevent of dif�culties. These arrangements — although having different modal-ities — all include a regular commitment fee. The Indonesian and Mexicanlines have been drawn; it is interesting that Mexico’s creditor banks initiallyargued against the drawing, even though as the IMF (1999, op. cit.) rightlyargues, Mexico had adhered strictly to the arrangement. However, the loanwas disbursed when Mexico requested it. Mexico’s Finance Minister Gurria6

argued that the creditor banks resented disbursing loans at the low spreadsthat had been pre-committed, at a time when spreads for Mexico and otheremerging market countries were much higher. A possible way to overcomesuch problems could be to, for example, link the loan spread, whenarranging the loan, to bond market yields prevailing at the time (Gray,1999). This could encourage creditors, but could — in times of crisis —increase the cost of such borrowing. The Argentina line has not been drawn,but its existence may have helped forestall market pressures.

This seems clearly an appealing mechanism. However, several ques-tions remain. First, would banks be willing to provide this kind of �nancialto a broad range of countries, including, for example, poorer ones. Second,do these facilities really provide additional �nancing in times of crisis, ordo they partly crowd out other lending? Even more seriously, could

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banks involved in extending credit lines adopt dynamic hedging strategies tooffset their exposure, as a consequence leaving their overall exposure to thecountry the same? This would clearly neutralize the positive impact of suchan arrangement.

Restricting derivatives in debt contracts

To reduce risk of loans, creditors like to introduce put options, which givethem the option (but not the obligation) of shortening the contractualmaturity of loans of bonds. For example, a 5-year loan — statisticallyrecorded as such — can have a 1-year put, which allows the creditor theoption of asking for repayment in 1 year, increasing his/her �exibility.Debtors accept such put options because it allows for somewhat lowerspreads; however, in doing so, they often under-estimate the risk thatconditions may deteriorate signi�cantly — as a result they may lose marketaccess — and the put may be exercized.

Put options have become an important additional source of vulner-ability for developing countries — including some low-income ones — asthese countries have increasingly accepted puts in past years, as derivativesbecame more widespread and as the risk of crises increased (for example,in Brazil, the share of ‘putable’ bonds increased signi�cantly as the crisisapproached). According to the IMF (1999, op. cit.), a minimum estimate of$20 billion in loans and bonds is ‘putable’ in 1999 alone, which is a veryhigh �gure.

It is therefore very important for countries to be far more careful thanin the past about accepting or using derivatives, such as put options, as wellas other such investments when these increase countries’ vulnerability tocrises. It is also important to improve transparency and understanding ofsuch modalitites and issues, as the operations of �nancial intermediaries areoften both complex and opaque. This may be particularly urgent forlow-income countries, where there may, as yet, be less familiarity with suchinstruments. Technical assistance (from the IMF, World Bank, BIS or others)could thus be very valuable, and particularly so for poorer countries.

Amending sovereign bond clauses

There is an urgent need to have �exibility in debt contracts for the case ofunpredictable shocks arising. In a national context, this can be achieved bybankruptcy proceedings. While this option is not yet available internation-ally (even though there have been several interesting proposals to establishone), a good ‘second best’ is to have internationally state contingentcontracts, i.e. to have �exibility for changing contracts if unforeseen circum-stances arise.

After the Mexican peso crisis, the discussion of such changes has beenparticularly applied to international bonds, possibly because emerging bond�nance has rapidly grown, with gross �ows of bond placements increasing

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from $6 billion in 1992 to over $40 billion in 1997 and 1998; this also leadsto rapidly growing amortization of bond �nance (particularly true for LatinAmerica). Indeed, it is unclear to what extent changes in the bondscontracts would have had a signi�cant impact on the East Asian crisis,where the greatest part of the problem related to short-term bank lendingand not to bonds.

Speci�cally, Eichengreen and Portes (1995) proposed changing thecontractual provisions governing sovereign debt to allow for: (a) collectiverepresentation of bondholders in the event of a crisis; (b) quali�ed majorityvoting on changing the terms and conditions of the debt contract; and (c)sharing of proceeds received from the debtor among creditors. Theseclauses would facilitate a more orderly resolution of crises; for example, bypreventing a minority of dissident investors from holding up settlement.More broadly, it would help overcome problems associated with lack ofcreditor coordination, particularly the creditor ‘grab-race’, whereby actionstaken by individual creditors in pursuit of their self-interest can disruptorderly debt workouts, and thus reduce the potential resources available toall creditors and help create a situation of panic.

The ideas for modifying bond contracts were supported by the 1996G10 Deputies report (after the Mexican crisis), by the G22 Working Groupon International Financial Crisis (after the East Asian crisis), and has beenboth supported and developed further in the 1999 IMF document on‘Involving the Private Sector’, quoted earlier. However, little concreteprogress has been made to date.

This lack of progress has two main reasons. On the one hand, mostcreditors are reluctant (see, for example, International Monetary Fund,1999); although some creditors, especially in Europe, see possible advan-tages in modifying bond clauses (for an interesting discussion, see Gray(1999)). On the other hand, debtors are concerned that such clauses couldrestrict future access, in terms of volume, or at least in terms of cost. Thisconcern needs to be evaluation seriously as long-term bonds are an import-ant mechanism for funding development. However, the view can also betaken that, once the market has accepted these changes, the clarifying of the‘rules of game’ could actually improve market access.

In any case, it does not seem appropriate for international institutionslike the IMF to impose, as part of conditionality, modi�cations to bondcontracts on developing countries, has been recently suggested. A verypositive way forward would be for G-10 sovereigns to include in their newbond issues the new contractual terms already discussed. This would havetwo positive effects: the G-10 would lead by example, and they would helpde�ne a new market standard. If the completely creditworthy G-10 coun-tries would modify their new bond contracts (which would be extremelyunlikely to increase their spreads), this would imply that it would becomefar more acceptable for developing countries to do so, and that negativeeffects on availability and cot of new bonds for them would deteriorate farless than if they did it on their own. However, there seems to be someresistance among G-10 governments for them to undertake such changes

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(unpublished interview material). The reasons given are purely technical,the problems raised seem relatively small, so they could be easily overcomeif political will was there. One problem is that not all G-10 countries arecurrently active in international markets; this could be overcome either bymodifying bond clauses only for those G-10 countries currently issuingbonds or by G-10 countries issuing bonds beyond their normal fundingprogramme. Another, highly technical, objection is that modifying bondclause covenants, for those G-10 countries where secondary markets arevery liquid and where parts of the bonds are ‘stripped’, could lead initiallyto some fragmentation of that strips market.

It is important to point out that the problems for restructuring bondsdo not apply to all types of bonds. Indeed, British-style bonds contain anumber of important characteristics that facilitate an orderly restructuring.This is because they include provisions for the debtor, bondholders or thetrustee (if there is one, see analysis later) to call bondholders meetings, andfor a quali�ed majority of bondholders represented to agree to changing theterms of the bonds for all holders. Furthermore, under one of two categoriesof British-style bonds (called Trustee Deeds), individual bondholders aregenerally prohibited from accelerating the bonds and initiating litigation. Asthe IMF (1999, op. cit.) points out, with British-style bonds it may be fairlyeasy to achieve high participation rates, as creditors that are reluctant toparticipate in changing conditions will know that they face the alternativeof a modi�cation of terms that can be imposed by a majority of bondholders.In the case of Trustee Deed bonds, the limits on individual creditors toinitiate litigation provides further incentive to participate in an orderlyrestructuring.

However, there are dif�culties in achieving an orderly bond restructur-ing after market access has been lost for countries with debt structured inthe form of American-style international bonds — the most prevalent bondsissued by developing countries — or by German-style bonds. Those instru-ments do not include provisions for majorities to modify terms of bonds,and impose those changes on minority holders. Furthermore, in case of adefault, the bonds have few limits on individual bondholders to start, andbene�t from, litigation.

It is interesting that until now there has been no premium in favour ofUS-style bonds, i.e. investors have not discriminated in favour of those more‘protected’ instruments, possibly because they have not noticed the differ-ence (unpublished interview material). This is rather encouraging, as itwould imply that drawing on the precedent of UK-style bond clauses andgeneralizing them would not increase the cost of borrowing for developingcountries. However, reportedly, some of the major rating agencies havestarted to examine the terms of speci�c sovereign debt obligations, withdistinctions being placed on technical nuances of different debt issues,which could possibly lead to differential pricing. Perhaps a problem hasbeen the excessive publicity given to the possibility of amending conditionson developing country bonds (without actually doing it), which has focusedtoo much attention on this issue. A more effective way could have been to

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modify the terms of new bonds — to make them similar to UK-style ones —without so much public discussion of the matter.

There is a second, more technical dif�culty, for rescheduling bonds.Currently, these bear the modality of bearer bonds, which makes it farharder to get bondholders together, so they can agree restructuring or otherchanges. This problem can, however, be remedied for new issues by theappointment by the issuer of a single trustee, who is empowered to act forbondholders. Such trustees can: (a) prevent bondholders taking unilateralaction; and (b) provide a useful channel for communication and possiblenegotiation between bondholders and the debtor (I thank Robert Gray forthis point).

The modi�cation of bond terms has attracted a lot of debate andattention, and could have important positive effects in that, in the medium-term, it could contribute very signi�cantly to orderly debt-workouts, and toa more level playing �eld among different categories of instruments. Theinitial impact on modifying debt servicing would be restricted by the factthat these changes would apply to new bonds only, and would not provide�exibility in the event of payments dif�culties for the large existing stock ofbonds. Furthermore, as already discussed, particularly if these changes wereintroduced only by developing countries, they could — especially initially— limit access and increase cost for them to this important source offunding.

There has also been growing international consensus on the need tocreate internationally sanctioned standstill provisions, although these pro-posals have been less well worked out by institutions like the IMF, especiallyon the legal aspects. However, it is important that the G22 report hadexamined alternative ways of achieving standstill-type arrangements, includ-ing ways in which the international community might be able to signal itsapproval for standstills in exceptional cases. Although countries shouldmake every effort to meet the conditions of all debt countries in full and ontime, in certain cases — the G22 report accepted — a temporary suspensionof payments could be a necessary part of the crisis resolution process. Thepreventive suspension of debt service and agreed rescheduling would helpto solve the coordination problem, typical when creditors panic and rushfor the door, and thus to help avoid some of the worse effects of suchout�ows. As a result, in a context of potential multiple equilibria, such apractice could lead to an equilibrium with higher output, less bankruptciesand, probably, less long-term disruptions to capital �ows.

The G22 report went further in recognizing that there may be extremecases when an orderly and cooperative restructuring process would beaided by “an enhanced framework for future crisis management”, that wouldallow the international community to signal its approval of a temporarypayments suspension by providing �nancial support for the crisis country.The G22 supported the IMF decision to extend its policy of lending tocountries in arrears on payments to private creditors. According to the G22,this signal (and the explicit support which the IMF would thus give to thestandstill) would only be provided where the international community

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believed the government’s decision to suspend debt payments was the onlyreasonable course open to it, that it was implementing a strong programmeof policy reform, and that it was making every effort to reach agreementwith creditors. The IMF would be signalling con�dence in the debtor’spolicies and long-term prospects, and indicating to creditors facing tempo-rary standstills that their interests would best be served by reaching quickagreement with the debtors. A standstill imposed as part of such a co-operative and non-confrontational process would hopefully be less penal-ized by creditors.

UNCTAD (1998), which has provided one of the most forceful anddetailed defences of the standstill mechanism, has suggested a possiblesecond alternative procedure to implement standstills. This would allowcountries to unilaterally call the standstill, but then to submit it for approvalto an independent international panel within a speci�ed period, whosesanction would then give it legitimacy. Such a procedure would be similarto WTO safeguard provisions allowing countries to take emergency actions.A third complementary possibility (Ocampo, 1999) would be to draft exante rules, under which the debt service would be automatically suspendedor reduced if certain macroeconomic shocks are experienced; such ruleshave sometimes been incorporated into debt renegotiation agreements (e.g.Mexican Brady bonds).

A problem may be that crises have both common, but also different,features, which may make it more dif�cult ex ante to de�ne the macro-economic shocks.

As regards any of these three alternatives, it can be argued that theywould increase perceived country risk, and therefore could increase costand limit access to international capital �ows for developing countries. Onthe contrary, it may be argued that such a mechanism would only legallyrecognize default risks that already exist, and that it could actually reducethe default risk for individual operations. Alternatively, it could be arguedthat if, especially initially, there was some increase in interest rates —especially by short-term foreign lenders — this could be good as it wouldmake those lenders focus more clearly on the risks involved in such lending;these risks extend beyond the parties to the transaction, to innocentbystanders — workers and small businesses — repeatedly hurt underexisting �nancial arrangements (Stiglitz and Bhattacharya, 1999).

In some ways, an even more radical proposal for a standstill has beenmade by Buiter and Sibert (1999); this suggests a universal debt roll-overoption with a penalty (UDROP). All foreign currency lending — private orsovereign, long or short, marketable or not — would have to have such aroll-over option for a speci�ed period (e.g. 3 or 6 months) at a penalty rate.The penalty rate would be high to discourage debtors using this option. Inthis proposal, the roll-over mechanism would be automatic, and activatedonly at the discretion of the borrower. As such, it would be speedy. Thisproposal has the important attraction of simplicity, speed and universality(both for all debtors and all instruments). However, it has two problems.First, it does not elaborate the legal and other mechanisms necessary to

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enforce it. Second, it seems somewhat unlikely that creditor countries’governments would accept such a mechanism, as it could be unattractive tocreditors.

To some extent, of course, some kind of concerted standstill for onekey category of debt — short-term, cross-border interbank credit lines —has been fairly successfully implemented in the recent crises in South Koreaand Brazil, even though the delays in arranging them led to fairly signi�canthaemorrhaging of out�ows before it was arranged. However, in SouthKorea, the concerted rollover of short-term bank lines was helpful instabilizing a critical situation, and also facilitated a restructuring of interbankclaims into sovereign guaranteed bonds. Also, Brazil was able to secureagreement of international banks to maintain their exposure to Brazilian�nancial institutions. However, there is a widespread view that, particularly,South Korea’s success re�ected specially favourable circumstances — suchas the problem being limited to short-term debt, with the rest of the capitalaccount fairly closed — which would be dif�cult to replicate in othercountries.

Furthermore, the fear has been expressed (International MonetaryFund, 1999) that concerted operations in one case could lead creditors towithdraw credit lines in advance of a crisis elsewhere for fear of a concertedrollover.

A broader standstill mechanism — than just concerted rollovers ofshort-term debt — seems very important to establish. However, the relativesuccess of existing rollovers or partial standstills, provides a valuable prece-dent for a more structured standstill mechanism.

Summary and conclusions

It seems important to attempt to evaluate progress so far, as regards thereform of the international �nancial architecture. A positive feature is that afairly important proportion of the proposals on the table by spring 1998 (fora review and analysis, see, for example, Grif�th-Jones and Kimmis (1998))have either been seriously studied or actually began to be implemented.This is particularly true for those proposals that do not require signi�cantinstitutional innovation.

Among the most positive steps are the creation of the Forum forFinancial Stability (FSF), the creation of new facilities of the IMF (including,most recently and signi�cantly, the CCL), as well as improvements ininformation, particularly on developing countries. However, the way inwhich each of these have been implemented have serious limitations, whichwe discuss later. Furthermore, in the areas of amending bond clauses andinternationally sanctioned standstill arrangements, little actual action hastaken place, although the discussion has become increasingly more speci�cand certain consensus seems to be broadly emerging.

As regards progress in global regulation of private �ows, the rapidcreation and beginning in the operation of the FSF is an important stepforward. However, the current lack of participation of developing countries

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in the decision-making Forum is a serious limitation, even though thesecountries do participate in the Working Groups, where important work isbeginning. Participation of developing countries — including low-incomeones — in this Forum is urgent, as they are the main victims of the volatilitythat this Forum is attempting to stem. Second, the Forum may need to bestrengthened in its decision-making power, as its purely coordinating andconsensus-seeking role may not be suf�ciently strong in the future.

Third, it is unfortunate that certain regulatory changes — on whichvery broad consensus has been reached — such as modifying capitaladequacy rules to reduce regulatory incentives for short-term bank lendingto developing countries, have taken so long to be made. Fourth, the initialpriority areas of work (highly leveraged institutions, offshore centres andcurbing volatility of short-term �ows) are extremely important; however,other areas — such as evaluating prudential regulation of other institutionalinvestors and such as mutual funds — could be usefully added.

As regards the creation of the CCL, this is also potentially an importantstep forward to limit contagion, by encouraging countries to adopt policiesthat will discourage crises happening and by signalling to the markets thatthis facility is available. Both may help avoid crises happening. However,there are several concerns about the way the CCL is being structured. First,would the scale be suf�cient to stem a crisis? Second, why is disbursement— in the stage of crisis threat — not automatic for countries that havepre-quali�ed? Third, why is the CCL not open to countries with current orexpected regular IMF �nancing? Fourth, will conditions be too restrictive,and thus make countries unwilling to negotiate CCL? Careful monitoring ofevolution of the CCL and its use is required, as well as continuous analysison the complex issue of how best of�cial liquidity can be used in emergency�nancing.

Much useful progress has also been made on improving information ondeveloping countries, which hopefully will help markets and policy-makersmake better decisions. However, the possibilities and bene�ts of improvedinformation have very important limits, both due to asymmetries of infor-mation and because of the signi�cance of how information is processed.Furthermore, more limited progress has until now been made on the equallyimportant issue of improving information on international �nancial markets.Much emphasis has also been placed on the development of numerousstandards, and their implementation by developing countries. A source ofconcern is that developing countries — especially low-income ones — donot on the whole participate much in the de�nition of those standards,although they are being asked to implement them. Both meeting standardsand enhancing information puts an important burden on developing coun-tries, especially low-income ones. As a consequence, technical assistance inthis �eld, especially to the poorer countries, is a priority.

As regards the issue of emergency measures involving the private sectorduring crises, some limited progress has been made, especially as regardsbroadening the power of IMF lending into arrears and the arrangement ofconcerted rollover of credit for Brazil and Korea. However, the larger issues

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have not yet been tackled, both because of their complexity and because ofdifferent interests and perspectives involved. It is important that concreteprogress be made on orderly debt work-outs, including particularly changesin bond covenants; interestingly, UK-issued bonds already have more�exible clauses, and these do not as yet carry higher spreads; this providesa very important precedent for modifying clauses in US and German bonds.It is, however, important that changes in these clauses are introduced bothby developed and developing country borrowers, to avoid stigmatizing andmarginalizing developing country borrowers. In particular, modifying bondcontracts should not be imposed by IMF conditionality on developingcountry debtors, as has been suggested. While bond covenants are notmodi�ed for all countries, including developed ones, developing countriesneed to have the freedom to decide whether they wish to modify them,assessing carefully costs and bene�ts of such a measure; the costs includepossible reduction in access to bond markets and possible increases inspreads, whereas the bene�ts include greater �exibility and better burden-sharing in times of crises. As regards internationally sanctioned standstills,even less progress has been made, although a number of interestingproposal have emerged on mechanisms, modalities and institutional arrange-ments.

As the Peruvian poet, C. Vallejo, has said, “there is still much to do” on�nancial architecture. This is particularly so because recent crises have hadan unacceptably high cost in terms of interrupting and, sometimes revers-ing, growth and development, increasing poverty, and discouraging futureprivate investment, both by national and foreign investors. These currencycrises also distract the international of�cial community from the crucial taskof increasing and improving of�cial �ows to low-income countries, whichneed to play a continued role in helping their growth and in supportingpoverty alleviation in them.

Although our report has focused more on issues of internationalmeasures to prevent and better manage crises, clearly these need to becomplemented by national measures, both in the prudential and capitalaccount regulatory area and in macroeconomic policy. Prudence in theliberalization of certain categories of capital �ows (the more volatile ones)is also an important area.

More generally, at a national level, the traditional emphasis on crisismanagement needs to be changed to the management of booms, since it isin the periods of euphoria from capital in�ows and terms of trade improve-ment that crises are incubated. This implies introducing stronger counter-cyclical elements in: (a) macroeconomic policy; (b) strengthening as well asincreasing counter-cyclical elements of �nancial regulation and supervision,to prevent excessive risk taking — indeed, prudential regulation must takeinto account not only the microeconomic, but also the macroeconomic riskstypical for developing countries in an increasingly globalized and volatileworld; �rm, as well as total, debt exposures need to be carefully monitored,as well as their pro�les, to prevent vulnerability to crises — and (c) ifexcessive short-term, potentially reversible, capital �ows enter the econ-

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omy, measures — such as Chilean-style or Colombian-style reserve require-ments — clearly need to be taken.

Acknowledgements

I thank of�cials in the UK and US Treasury, Bank of England and FederalReserve Board, as well as colleagues in private institutions for valuableinsights. The responsibility is, as always, my own.

Notes

1 A recent survey of banks by the Bank for International Settlements showed that most ofthem took decisions without taking much notice of information available in research andother departments even within their own bank.

2 The literature on national regulations is extensive. See, in particular, among recentcontributions, World Bank (1998a, Chapter 3), Economic Commission for Latin Americaand the Caribbean (1998a,b), Ffrench-Davis (1999), Helleiner (1997a) and Ocampo(1999).

3 This important distinction is made by Helleiner (1999).4 The SRF was implemented at the end of 1997 as a response to the Asian �nancial crisis.

It provides �nancial assistance for exceptional balance of payments dif�culties due to alarge short-term �nancing need resulting from a sudden and disruptive loss of marketcon�dence. Up to now, SRF loans have been made to Korea, $2.8 billion, Russia, $0.9billion, and Brazil. The lending terms for the SRF are similar to those for the contingencyfacility.

5 In April 1999, the Fund had $76 billion in uncommitted resources plus $46 billionavailable under pre-arranged credit lines.

6 Presentation in May 1999 at HSBC, London; personal communication.

References

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Agosin, Manuel and Ffrench-Davis, Ricardo (1999) ‘Managing capital in�ows in Chile’,in Stephany Grif�th-Jones, Manuel F. Montes and Anwar Nasution (Eds.), Short-Term Capital Flows and Economic Crises, Oxford University Press and UNU/WIDER,England.

Bhattacharya and Miller (1999) ‘Coping with crisis: is there a silver bullet? in R. Agenor, M.Miller, D. Vines and A. Weber (Eds) The Asian �nancial crisis: causes, contagion andconsequences, Oxford University Press (forthcoming).

Borio (1998) ‘Institutional investors’, Mimeo, B.I.S., Basle.Calvo (1998) ‘Capital �ows and capital market crises: the simple economics of Suddan stops,

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and divergence’, Serie Temas de Coyuntura No. 1, Economic Commission for LatinAmerica and the Caribbean, Santiago.

Ocampo, Jose Antonio and Tovar, Camilo (1998) ‘Capital �ows, savings and investment inColombia, 1960–96’, in R. Ffrench-Davis and H. Reisen (Eds) Capital Flows and Invest-ment Performance: Lessons from Latin America, Economic Commission for Latin Americaand the Caribbean/OECD Development Centre, Paris and Santiago,.

Stiglitz, J. and Bhattacharya, A. (1999) ‘Underpinnings for a stable and equitable global�nancial system’ paper prepared for 11th World Bank, Conference on DevelopmentEconomics, April 28–30.

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Tietmeyer, H. (1999) Report by the President at the G-7 meeting in Bonn, February,Deutsche Bundesbank.

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Appendix 1 : tran sparency and standards (Source: IMF web site)

Transparency

Basic objective. Help foster better decision-making and economic performance byfurther improving transparency in the policies and practices of member countriesand international institutions.

The IMF’s role. Encourage member countries to be more transparent. Become moreopen about IMF policies and advice to members, while respecting legitimate needsfor con�dentiality and candor.

ProposalMake available more information on IMF surveillance of membercountries.

Speci�c proposals. Actively encourage members to release PINs followingArticle IV consultations. Take steps to accelerate their release. Post PINs on theIMF external website. Allow the voluntary release of Article IV staff reports.Increase access to the Fund’s archives.

Progress to Date. Most steps agreed/reaf�rmed by the Executive Board inJuly 1998 and/or March 1999 (See PIN 99/36). PINs were being releasedfor about 70% of Article IV consultations, as of the latter part of 1998. Thelag between the Board discussion and the issuance of the PIN has beenshortened, and the number of modi�cations reduced. In March/April 1999, theExecutive Board authorized an 18-month pilot project for the voluntary releaseof Article IV staff reports, and shortened the time limits for access to thearchives.

Next steps. IMF: evaluate the Article IV staff report pilot project within 18months. Review the archives policy in 2 years, with a view to possible furtherliberalization. National authorities: actively consider the release of PINs follow-ing Article IV consultations. Volunteer for the pilot project for release ofArticle IV staff reports.

ProposalMake available more information on countries’ IMF-supported programs ofeconomic reform and adjustment.

Speci�c proposals. Actively encourage members to release to the public theLetters of intent and Policy Framework Papers (PFPs) underpinning Fund-sup-ported programs, and post the released documents on the IMF externalwebsite. Publish the Chairman’s remarks following Board discussions of theuse of Fund resources (UFR). Allow for the voluntary release of PINs and staffreports on requests for, or reviews of, the use of Fund resources.

Progress to Date. Release of LOIs/PFPs and posting on the IMF externalwebsite was begun in December 1997. In March/April 1999, the Board agreedon a ‘strong presumption’ that LOIs and PFPs would be made public bymember countries, and to proceed with the release of the Chairman’s remarksin UFR cases.

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Next steps. IMF: make new policy known to members. Revisit the question ofPINs for UFR discussions and the release of UFR staff reports in six months.Review policies further after 1 year. National authorities: release LOIs andPFPs.

ProposalMake available more information about IMF analyses of policy issues.

Speci�c proposals. Broaden the use of PINs beyond Article IV consultations toinform the public of the Executive Board’s conclusions following policy andregional surveillance discussions. Release more IMF staff papers on policyissues.

Progress to Date. The release of summings up on policy discussions wasagreed by the Executive Board in July 1998, and the �rst policy PIN, on theExecutive Board discussion of SDDS reserves data, was issued in March 1999.Various staff papers have been released, e.g., in January 1999, ‘IMF-supportedprograms in Indonesia, Korea and Thailand: a preliminary assessment’, alongwith the Chairman’s Summing Up of the Executive Board’s discussion of thereport, and, in April 1999, ‘Involving the provate sector in forestalling andresolving �nancial crises’ and ‘Experimental case studies on transparensypractices’.

Next steps. IMF: staff papers on policy issues along with the Summing Up/PINto be released on a case-by-case basis. Finalize guidelines for the release of PINson policy discussions. Review the PIN policy by March 2000.

Internationally accepted standards

Basic objective. Foster the development, dissemination, and adoption of internation-ally accepted standards or codes of good practice for economic, �nancial, andbusiness activities.

The IMF’s role. Help develop or re�ne standards in its core areas of expertise (datadissemination, transparency of �scal, monetary, and �nancial policies, and, inconjunction with others, banking supervision). Assist in the dissemination ofstandards, their adoption by members, and the monitoring of their implementation,including, as appropriate, standards in areas outside the Fund’s direct operationalfocus, e.g. accounting and auditing, bankruptcy, corporate governance, insuranceregulations, payment and settlement systems, securities market regulation, etc.

ProposalStrengthen the SDDS.

Speci�c proposals. Strengthen, in the areas of international reserves andexternal debt, the SDDS, the standard established by the IMF in 1996 to guidecountries that have or might seek access to international capital markets in thedissemination of economic and �nancial data to the public. Establish proce-dures for monitoring observance of the standard. Consider inclusion of ‘macro-prudential’ indicators, variables that can indicate the health of the bankingsector.

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Progress to Date. The Executive Board in December 1998/March 1999 agreedto strengthen the SDDS in the areas of debt and international reserves, and todevelop monitoring procedures (See PIN 99/25). The IMF is considering theadvantages and disadvantages of incorporating macro-prudential indicators inthe SDDS.

Next steps. IMF: establish monitoring procedures; consult with compilers; anddraft operational guidelines on international reserves data. Of�cial internationalbodies: The BCBS to coordinate with the IMF on developing macro-prudentialindicators. The Committee on the Global Financial System to collaborate withthe IMF in the preparation of operational guidelines on reserves data. Nationalauthorities: contribute to the development of operational guidelines. Subscrib-ing countries to comply with the provisions of the SDDS; others to considersubscribing to the SDDS or the General Dissemination Standard, as appropri-ate, and take the necessary steps.

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Towards a Better Financial Architecture

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