February 2, 1999
Building on a consensus
The private sector could play an important role in helping the IMF to set up a new international financial system
By Barry Eichengreen
The crisis that erupted in Thailand in 1997 left Bangkok's skyline studded by unfinished sky-scrapers and half-built architects' dreams. One fears that the same fate will now befall that other set of architects - the ones seeking to rebuild the international financial system. That process now resembles nothing so much as an open competition for a lavish commission. Anyone with a pencil has submitted a plan.
Judges of architectural competitions winnow submissions by rejecting those that fail to conform to the site or exceed the engineering capabilities of the builders. A first step towards a consensus on financial reform is to reject grandiose schemes for which there is no political support.
However compelling the argument that global financial markets require a global financial regulator, global bankruptcy court, global money, and a global central bank, realism requires acknowledging that national governments are not prepared to turn over significant additional powers to a super-International Monetary Fund. Europe has created a single currency and a European Central Bank only after half a century of hard slog. It is fantastic to think that this process could be replicated on a global scale in a few years.
What remains is a limited agenda, but an important one. The first element is the need for international financial standards. It is impossible to fix the international financial system without first fixing the domestic financial systems of countries active on international markets. But neither the IMF nor any other multilateral agency has the resources to micro-manage this process in 182 countries. The only practical approach is to develop and adopt international standards of acceptable practice, not just for bank regulation but also for auditing and accounting, corporate governance, and bankruptcy law as well. National practices can differ in their particulars, but all must satisfy a common set of international standards.
In doing this, the lead must be taken by the private sector: by the International Accounting Standards Committee, Committee J of the International Bar Association, and others. The IMF can help enforce these standards by issuing blunt assessments of national practice and offering concessionary interest rates on its loans to countries that comply.
A second critical area concerns banks and capital flows. Everyone agrees on the need to strengthen banks' risk management and supervisors' oversight and regulation. But the sad truth is that banks in too many countries have a limited capacity to manage risk and that regulators have limited capacity to supervise their actions. In such countries, moreover, capital requirements in theory and capital requirements in practice are two different things. Consequently, revising the Basle Capital Standards to make capital requirements sensitive to the source of banks' funding as well as the riskiness of their investments is unlikely to prove effective.
The basic problem is that free access to foreign finance, short-term finance in particular, is incompatible with financial stability. Foreign funding gives banks gambling for redemption and otherwise seeking to take on excessive risk an additional way to lever up their bets.
Government guarantees for banks regarded as too big to fail encourage foreign investors to provide those funds. And when confidence is disturbed, the short maturity of their loans provides these investors the opportunity to flee. Their rush for the exits can bring down not just the banking system but the currency and the economy as well.
This creates an argument for limiting short-term bank borrowing abroad in countries where banks' risk-management practices and regulatory supervision do not suffice. And where banks can circumvent these measures by having the companies do the borrowing and pass on the proceeds to them, broader measures may be required. Financial stability may have to be buttressed by a Chilean-style tax to limit short-term foreign borrowing by all domestic entities. The international community should become an unambiguous advocate of these measures.
A last area where there exists a reasonable degree of consensus is on changing the provisions of loan contracts. Majority voting and sharing clauses should be added to loan contracts to prevent isolated creditors from resorting to lawsuits and other means of obstructing settlements. This is the only practical way of creating an environment more conducive to restructuring negotiations. Unfortunately, this is a process in which no borrower wants to be first. The IMF will have to make clear that it will lend at more attractive interest rates to countries that issue debt securities with these provisions. US and UK regulators should require the relevant provisions of international bonds admitted to trading on their markets.
Finally, it is important for aspiring architects to draw the right lessons from the Brazilian debacle. IMF protestations not withstanding, one indisputable lesson is the need for the vast majority of emerging markets to move to more flexible exchange rates. Brazil illustrates yet again that, in a world of high capital mobility, democracies cannot credibly attach priority to the maintenance of pegged exchange rates above all other goals of policy.
Brazil is also a blunt reminder both of how few countries have the kind of unquestionably strong policies that might permit the IMF to extend unconditional credits in advance and of how small the Fund's resources remain relative to those of the market. The new "contingent facility" for the IMF, as suggested by the Clinton administration and the Group of Seven, is not a feasible response.
This week's meeting in Davos was yet another occasion for the pundits to flog their pet plans. Most of their ideas are not practical guides for policymakers. The time for this is over. The task now is to move from abstract schemes to concrete action. This means discarding unrealistic proposals and building a consensus around those that remain.
The author is professor of economics and political science at the University of California, Berkeley