How To Reshape The World Financial System
"Sound management of fiscal and monetary policies provides no guarantee against major economic crises."
--International Monetary Fund, September, 1998
It once was comforting to believe that the international financial system was a just and fair god. Countries that ran big budget deficits and borrowed from overseas to finance consumption, rather than investment, would be punished by capital flight and depreciating currencies. Nations pursuing prudent policies would be rewarded by strong growth and a steady stream of money from global investors.
But when the world's top finance ministers and bankers gather at the beginning of October in Washington for the annual meetings of the International Monetary Fund and the World Bank, they face a different reality. Despite being held up for years by the IMF as models of development for the rest of the world, countries such as South Korea, Thailand, Malaysia, and Indonesia have been ravaged by capital flight.
To date, the IMF-led rescue plans for these nations do not appear to have worked. Unemployment and interest rates have soared, the value of their currencies has plummeted, and prosperity has turned into social dislocation and riots. The flow of private funds into these countries has screeched to a halt. Even Thailand, which has made impressive progress in modernizing its financial and legal systems, will not see a full recovery for years. Overall, the stricken Asian economies will shrink by more than 5% this year, according to forecasts by Standard & Poor's DRI, vs. 5.8% average growth in 1996 and 1997.
What's more, the rescue effort does not appear to have halted the rolling crisis, which has hit other emerging markets such as Russia and Latin America. The latest victim: Brazil, whose stock market has dropped by almost 40% since mid-July as it battles the perception that its financial situation, too, is becoming unsustainable (charts, page 114). The fear now is that a series of defaults would cause an unraveling of the global financial system, bringing international lending and borrowing to a halt. The tremors have even reached the U.S., with the collapse of giant hedge fund Long-Term Capital Management.
There is little argument that today's global financial system needs to be rebuilt. The goals are obvious: Reducing the likelihood of future financial crises, preventing today's problems from spinning out of control, and restarting battered economies. At the same time, any fix needs to preserve and even strengthen the global flows of trade and foreign direct investment. These flows, which helped fuel the Asian miracle of the past 20 years, are the foundation for restoring growth in the future.
There is no perfect solution to the global mess--but BUSINESS WEEK believes there are ways to make things better. Some steps are easy: Everyone agrees that there needs to be better information and heightened regulation, both in developing and industrialized countries. But the far bigger task is to tame the anarchic nature of the global financial markets.
THE IMF OPTION. International finance is no longer the province of a relatively small number of large financial institutions. With the growth of rapid communications, investment banks, mutual funds, hedge funds, and multinational corporations all can jump in and out of markets at the click of a mouse. At the same time, financial wizards are creating swarms of new types of securities--ranging from derivatives to emerging- market debt--where the risks are hard to assess and price correctly.
Indeed, the current crisis stems, in part, from the breakdown of pricing discipline in global markets. Capital poured into emerging economies with little attention to the creditworthiness of the borrowers. As a result, countries like Thailand and Indonesia were able to borrow in dollars at far lower interest rates than they would be required to pay at home, encouraging them to take on far more foreign debt than they could handle.
When problems arose, everyone tried to get their money out as quickly as possible, making the crisis even worse. Complicating matters still more, there were no clear guidelines for which private-sector lenders had to share the cost of cleaning up the financial mess.
Not surprisingly, the road to restoring stability is not so clear. Economists and policymakers see three main alternatives for getting the global financial system under control. The first option would pump a lot more funds into the IMF--giving it enough resources to bail out troubled countries and get them back on their feet again. In effect, the IMF would be turned into a real lender of last resort for the world economy, much as the Federal Reserve serves as the last line of defense against the collapse of the U.S. financial system.
The danger of counting on the IMF, though, is the "moral hazard" problem. Assuming that they would be bailed out, investors would be encouraged to take bigger and bigger risks in emerging markets, leading to the possibility of even deeper financial crises in the future. Eventually, the crises would get so large that even a souped-up IMF could not handle them. Moreover, the IMF can never function as a true lender of last resort, since it will never have the Fed's most potent weapon--the ability to print money.
FLOW VALVES. An alternative being given increasing consideration is the imposition of controls on international capital movements. The goal would be to damp down the tidal surges of "hot money" that helped overwhelm the emerging economies of Asia and Latin America. The notion is attractive to government leaders faced with a sinking economy. In Malaysia, for example, Prime Minister Mahathir Mohamad imposed an indefinite moratorium on capital outflows. But the idea of limited capital controls is picking up support among top economists as well. World Bank Chief Economist Joseph E. Stiglitz argues, for example, that it's time to consider "some form of taxes, regulations, or restraints on international capital flows."
Indeed, there is some evidence that capital controls can be effective in protecting an economy from the global markets. In 1991, for example, Chile imposed a 30% tax on incoming portfolio investments, refundable after a year, in an effort to slow money coursing in so fast it was creating an inflationary bubble. From 1991 to 1997, inflation declined from 22% to 6.1%, while the country averaged more than 8% annual growth.
Nevertheless, the Chilean example cannot be counted a complete success. Chilean businesses that needed funds went offshore in such great numbers that three-quarters of all trading in Chilean equities now occurs on the New York Stock Exchange. And many businesses have tried to circumvent the capital controls by smuggling, bribery, and false invoices. Indeed, Chile recently dismantled its beloved controls in an effort to help the private sector get financing during the global market turmoil. "It's paradoxical that so many are advocating a [Chilean-style] system that has been repudiated by its very developers," says Sebastian Edwards, the World Bank's former chief economist for Latin America.
Indeed, because of the acknowledged limitations to capital controls, economists and policymakers are searching for another way to tame risk that won't require countries to take a step back from open capital markets. A big part of the problem is that there are no explicit rules for quickly resolving a financial crisis. The ad hoc approach worked in the past, when a debt crisis consisted of a handful of money-center banks lending to a government. Today, however, such crises can involve thousands of banks, mutual funds, and hedge funds, all lending to a slew of public and private debtors.
Without a formal workout process, precisely the wrong investors--those people who provide long-term money--take the bath. Equity and bond investors get hit hard, but perversely, when the IMF comes in with a bailout package, much of the currency infusion actually goes to pay off the short-term foreign lenders who helped cause the problem. "If you had a bond in an Indonesian company, you got wiped out," says Robert Litan, an economist at the Brookings Institution. "But if you made a foreign-currency loan to an Indonesian bank, you got off scot-free."
What's needed is gradually to change the rules to make all private-sector investors bear their fair share of the cost of a rescue effort, and not to favor providers of hot money. One proposal under consideration is a debt-restructuring plan akin to a Chapter 11 bankruptcy proceeding. Such a system, as outlined by proponents such as Harvard University professor Jeffrey D. Sachs, would allow a country in trouble to enjoy a temporary standstill on debt payments, with the approval of the IMF. Creditors and debtors would come to an agreement in an orderly manner on whether the debt should be marked down or exchanged for equity.
An approach like this could help revive moribund economies by providing what is in effect "debtor-in-possession" financing, giving special rights to those who provide credit after the original bankruptcy is declared. This would allow countries to tap new private capital, just as Chapter 11 in the U.S. allows bankrupt companies to get the credit they need to keep operating. The global equivalent would allow countries to get enough foreign exchange loans, guaranteed for a limited amount of time by the IMF, to allow exporters to keep functioning.
INCENTIVES. Formally bringing the private sector into the rescue process would cut the likelihood of future financial crises. Because lenders know they would not be bailed out by the IMF, they would have an incentive to pay closer attention to the quality of their investments. They would also likely want higher returns on money invested in emerging countries. As a result, the existence of a bankruptcy option could moderate flows of destabilizing hot money to emerging markets.
When a financial crisis does occur, a borrowing country would be less likely to be crushed under the weight of its bad debts. Instead, the losses would be shared with institutions that made the loans originally, with the goal of getting the country back to economic health as soon as possible. This would reduce the chances of a spillover to other emerging countries. Moreover, if existing debt can be marked down or rolled over quickly, it becomes easier for a country that hit the skids to tap private capital markets again.
Of course, a global system modeled on Chapter 11 might not help every country with financial woes. Russia, for one, suffers from such severe internal problems that no fixes to the international system are likely to help. Japan, the linchpin of the Asian economy, is stuck in recession, unable to address its own enormous debt problems because of political paralysis.
Beyond that, some bankers object that allowing debtor countries to get out from under some of their obligations is a recipe for disaster. A Chapter 11 for nations is "the worst idea I've heard in my life," says Paulo Ferraz, CEO of Banco Bozano Simonsen, one of Brazil's premier investment banks. "It would be the end of the global financial system."
"GET REAL." Moreover, many people are profoundly skeptical that such a proposal is anything more than an academic exercise. For one, unlike the U.S., the legal framework to compel creditors to accept a Chapter 11-type workout does not now exist on a global scale. In addition, some of the mechanisms that make Chapter 11 work in the U.S., such as the ability of creditors to shut down firms that are not economically viable, may not apply when the borrower is a sovereign nation. Even Treasury Secretary Robert E. Rubin, who thinks the notion is "a conceptually sound idea," admits to having doubts. "How you actually implement such a thing in an international regime where there is no Chapter 11 is a challenge," he says.
Nevertheless, the broad notion of moving toward a formal debt-restructuring system for the global economy is getting a great deal of attention these days. On Sept. 14, for example, President Clinton called for measures "to lift the weight of private-sector debt that has frozen the Asian economies." His urging followed the Bank for International Settlements' June suggestion that "the private sector [needs] to take some responsibility for the ongoing provision of credit to customers to whom they had previously lent All too freely." The Group of 22--consisting of the G-7 industrial countries plus 15 emerging economies--is also discussing new ways of dealing with private-sector debt.
In fact, history suggests that in times of crisis, demanding full repayment of debt can be an enormous mistake. After World War I, the victors' moves to collect war debts from each other and reparations from Germany helped create the conditions that bred the Great Depression and World War II. In the 1980s, Latin America struggled for years under debt problems untIl a deal was struck allowing capital to flow in and growth to resume. By contrast, the U.S. system doesn't require companies or people who fall on hard times to spend the rest of their life paying debts back. "Once your old mistakes get big enough, they drown your future," says Elizabeth Warren, a bankruptcy expert at the Harvard Law School. "Bankruptcy is a way to say to creditors, `Get real. The money's not there."'
Perhaps the hardest problem is how to decide when a debt standstill is appropriate. Clearly, it's important that a country not be able to unilaterally declare a debt moratorium--that's a sure route to chaos. Instead, the IMF should take the lead role in certifying when a country is in deep enough trouble to trigger the restructuring mechanism.
Both capital controls and a Chapter 11-type system have pluses and minuses. In the short run, capital controls are clearly an easier policy to adopt. Countries can implement them unilaterally, and they do not require new financing. By contrast, a formal debt-rescheduling scheme would be much harder to actually put into practice.
But capital controls do not solve the underlying problems of the world financial system. Rather, they are a temporary stopgap. A set of rules for global financial markets that codifies the now messy process of debt rescheduling may be difficult to achieve any time soon. But in the long run, moving in the direction of a system that prices risk appropriately and keeps capital markets open is the right thing to do.