Turning a blind eye to the systemic nature of financial instability is neither responsible nor acceptable. Global surveillance and regulation have lagged behind the integration of financial markets - with increasingly costly consequences. Crisis management requires a mix of old and new techniques in order to reduce the volatile movements of international capital. These themes are among the highlights of the UNCTAD Trade and Development Report, 1998(260 pages), released today. The Report recommends that debtor developing countries facing a speculative attack on their currencies should have the right to impose unilateral standstills on capital transactions like the trade safeguard actions permitted under WTO rules.
Financial instability has become a familiar feature of the global economy of the 1990s, and with each crisis the damage to the real economy, particularly in the developing world, has increased. The cost of the East Asian crisis is estimated by UNCTAD at about 1 per cent of global output (or some US$260 billion) this year alone. (see TAD/INF/PR/9822).
While these crises do not follow a single pattern, the Report highlights some recurrent features. Banking crises are often linked to speculative bubbles. Currency crises are often preceded by sharp increases in capital inflows, attracted by a combination of interest rate differentials and stable exchange rates. The deterioration of external balances and the weakening of financial sectors are two related aspects of the same process of excessive capital flows. Rather than reflecting shifts in domestic policy, reversals of capital flows are often associated with a deterioration in macroeconomic conditions resulting from the effects of the inflows; and both capital inflows and outflows are typically affected by financial conditions in the leading industrial countries. These factors and processes are particularly relevant in economies that have undergone across-the-board financial deregulation and liberalization.
Many of these more systemic features of the international financial system have not been appropriately taken into account, because of an exaggerated faith in markets and the discipline that they impose on policy makers. As a result, the Report says, insufficient attention is being given to "major shifts in macroeconomic indicators external to the countries where the crises first manifest themselves [such as] impulses resulting from the monetary and exchange rate policies of the United States and a few other OECD countries which exert a strong influence on ...capital movements".
The Report also rebuts the notion that inadequate information played a decisive role in the East Asian crisis, while noting that improvements in the timeliness and quality of information concerning key macroeconomic and financial variables can make an important contribution to better decision-making by investors, policy makers and regulators.
Much of the activity of financial markets is no longer related to wealth and job creation, the Report states; rather, it is concerned with speculation and arbitrage. Furthermore, as UNCTAD points out, herd-like behaviour has a major impact on the entry and the exit of investors. Regardless of the trigger, a sudden withdrawal of capital and a massive and sustained attack on the currency can rapidly degenerate into a panic. Under these conditions, tightening monetary policy may simply intensify the stampede, further undermining creditworthiness and increasing the risk of default. The scale of the problem can quickly overwhelm market-based solutions.
The Report offers policy makers a few commonsense lessons:
- First, the worst time to reform a financial system is in the middle of a crisis.
- Second, when the currency turmoil is associated with financial difficulties, raising interest rates over an extended period simply worsens the problem, by causing widespread corporate and bank insolvencies.
- Finally, currencies should not be left to float and sink, while international rescue funds are used to bail out international creditors.
Intervention by the international community in the form of bailouts also faces a dilemma. On any objective assessment, looking at the East Asian experience over the past year, international financial assistance provided multilaterally or bilaterally has been too little and too late, and has tended to favour the demands of creditors over the needs of debtors. In some quarters this is seen as generating "moral hazard", with the consequent calls to rein in such assistance. But, in the absence of sufficient liquidity to counter currency attacks, widespread defaults and bankruptcies inevitably follow.
Essential tools: debt standstills and capital controls
Given the increasingly private nature of developing countries’ external debt coupled with the political obstacles to ever larger bailouts, UNCTAD calls for a very different response to managing financial crises.
The extension and the application of insolvency principles to currency attacks offer a viable and plausible alternative. These would allow for a standstill on debt servicing to ward off predatory investors and give a country the breathing space needed to design a debt reorganization plan, thereby helping to prevent the liquidity crisis from escalating into a solvency crisis.
However, a full-fledged procedure, analogous to Chapter 11 of the United States Bankruptcy Code, is neither practical nor necessary. Article VIII of the IMF’s Articles of Association could provide a legal basis for the imposition of a debt standstill. This could be combined with "established practices for restructuring debt". The decision to impose a standstill could be taken unilaterally by the country experiencing a currency attack; and evaluation of its justification could be the responsibility of an independent international panel established for this purpose.
Prevention is the best cure
Prevention, UNCTAD believes, remains the best cure for financial crises; but many proposals in this regard are inadequate. "The alternative of freely flexible exchange rates, combined with capital mobility, would undermine currency stability with [unfavourable] attendant consequences for trade, investment and growth." Currency boards "do not insulate economies from instability of external origin" and can have effects which threaten banking stability. Strengthened prudential regulation can reduce the likelihood of financial crises but "experience indicates that, owing to the vulnerability of the financial sector to changes in economic conditions and to unavoidable imperfections in the regulatory process itself, even a state-of-the-art system of financial regulation does not provide fail-safe crisis prevention".
Elements for a more effective policy framework for the prevention of financial crises highlighted in the Report include:
- Adopting a more even-handed approach to policy surveillance; one which recognizes the destabilizing impact on other countries of changes in interest rates and exchange rates in the larger industrial economies;
- Encouraging regional consultation and collaboration. This can be particularly helpful in preventing currency disorders and contagion of others;
- Permitting policy makers in developing countries flexibility to introduce capital controls - a proven technique for dealing with volatile capital flows. As the Report states, these "will remain an indispensable part of developing countries’ armoury of measures for the purpose of protection against international financial instability".