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«GETTING IT RIGHT: WHAT TO REFORM IN INTERNATIONAL FINANCIAL MARKETS Eduardo Fernandez-Arias and Ricardo Hausmann Paper presented at the Tenth ...»

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Inter-American Development Bank

Banco Interamericano de Desarrollo




Eduardo Fernandez-Arias and Ricardo Hausmann

Paper presented at the

Tenth International Forum on Latin American Perspectives

Paris, November 25-26, 1999

Jointly organized by the Inter-American Development Bank and the OECD Development Center REVISED DECEMBER 15, 1999 The views and interpretations in this document are those of the authors and should not be attributed to the Inter-American Development Bank, or to any individual acting on its behalf.




Several reports on reforming the international financial architecture have been, are being, and will be produced by multilateral organizations, think tanks, freethinkers, and G-n task forces, with n taking values between 7 and 33. 1 The question is whether any of the initiatives will solve the important problems in international financial markets and be implemented before a temporary cease-fire on the financial battlefield is misinterpreted as the end of the war.

This paper provides an overview and assessment of reform initiatives, both those currently on the table and those that are not but we think should be. The intent is to clarify the logic behind these proposals and assess them from a Latin American perspective. Our discussion is based on the extent to which reform initiatives alleviate the problems we identified in the companion paper “What’s Wrong with International Financial Markets,” (Fernandez-Arias and Hausmann, 1999). The overall conclusion is that the current approach to reforming the international financial architecture is not apt to the task and requires a paradigm shift.

An initiative may obtain a bad grade for many reasons. First, it may have a negligible impact on the workings of the international financial architecture, i.e., it fails to address a substantial problem. Second, it may have a significant impact on financial markets but narrowly fit the interests of capital-exporting countries, as opposed to the needs of emerging markets. In both cases, proposed reforms would miss a historical opportunity to shape international financial institutions to support economic development. Finally, and most importantly, proposals may be counterproductive from a developmental perspective.

We are concerned with the possibility that an initiative may have a negative developmental impact because nearly all of the proposals currently under active consideration or experimentation entail less capital flows to support development in emerging markets. This outcome comes as a result of fighting moral hazard or as an expedient to reduce financial instability. In terms of the clusters of distortions identified in our companion paper (Fernández-Arias and Hausmann 1999), we are concerned that some alleviation of the distortions underlying the Theories of Too Much may severely aggravate the distortions behind the Theories of Too Little or Theories of Too Volatile.

There is a good chance that our reservations with the initiatives currently being advanced in international fora owe more to our Latin American perspective than to purely technical differences is their assessment. Our assessment is based on the efficiency of the proposed reforms: the deeper financial integration supporting high returns in capital scarce emerging markets, the better. It is clear, however, that an efficient architecture 1 Eichengreen (1999) provides an interesting survey of the main proposals on the table, and The Economist, (1999) gives a very useful summary discussion on the topic.

To name some of the initiatives on the table:

Bergsten (1998), Bergsten and Hennig (1996), Calomiris (1998), Camdessus (1998), Edwards (1998), Fischer 1999), Garten (1998), Government of France (1998), Government of the United States (1999), G-7 (1998), G-10 (1996), G-22 (1998a,b,c), G-30 (1997), Kaufman (1998a,b), Kenen (1998), Lita et al (1998), Meltzer (1998), Naciones Unidas (1999), Raffer (1990), Rogoff (1999), Sachs (1998), Soros (1997, 1998), Stiglitz (1998).

2 entails financial support from developed countries from time to time when things go wrong. From this alternative perspective, it would make sense to prefer reforms that limit financial risks, even at the cost of efficiency. The current bias in favor of reforms that limit capital flows may be better interpreted in this way rather than on efficiency grounds.

In this paper, we analyze the degree to which the initiatives effectively address the distortions in each one of the three clusters of theories. In the case of conflicting effects across this three-way typology, we refine the ambiguous assessment that would follow by weighing the tradeoffs involved. This evaluation methodology demands the consideration of the relative importance of each type of distortion for the problem at hand, for which we use the conclusions of the above-mentioned companion paper.

A key advantage of this joint analysis across distortions is that it makes explicit what economists refer to as the second-best theorem: the elimination of any one specific distortion may fail to improve welfare in the presence of remaining distortions. In fact, the single most important problem with the way the debate on reforming international financial architecture is being conducted is its partial, even unilateral, approach to the problems to be solved. But we must remember that reducing any identified distortion is not necessarily good policy and that successfully alleviating a specific undesirable symptom is not necessarily the manifestation of a welfare improvement. This is always the case when there are multiple distortions.

For example, the objective of reducing the moral hazard induced by official guarantees to international private capital flows would be served by curtailing official financial support to countries in distress. However, such financial support would be extremely beneficial in the event of a liquidity crisis and financial contagion. The overemphasis on moral hazard would lead to counterproductive policies if the latter distortions are preponderant. Similarly, reducing the incidence of crises by impeding capital flows to a sufficient extent may be a counterproductive policy once the deleterious growth effects of lower capital integration are factored in.

In this paper, we concentrate on a number of core initiatives that characterize the main angles of the debate. We omit other initiatives, not because they are without use or importance but because they are either uncontroversial or propose changes that are more decorative than foundational, i.e., they take too many walls and windows for granted.

For example, we do not discuss standards on transparency because we see them as uncontroversial but also of limited impact.

For each core initiative examined in this paper, both currently on the table and those that we propose for consideration, we first identify which of the main distortions identified in the companion paper it addresses. This correspondence between initiative and distortion provides a clear relationship between the problems diagnosed and the solutions reviewed. We then assess the initiatives by weighing the benefit concerning the distortion they are designed to alleviate and the possibly unintended effects concerning other distortions. 2 We group the initiatives examined in this paper into three sets and review them in turn. The first two sets of initiatives involve the provision of financial support triggered after an emergency arises. First, we consider initiatives concerning the unilateral provision of financial support by the official sector. Second, we consider initiatives in which the private sector is also given a role in providing financial support. Finally, the 2 We also compare initiatives that are mutually incompatible.

3 third set of initiatives refers to reforms to the financial institutional framework in which international capital flows to emerging markets take place. They encompass standards and regulations applicable to financial systems, both national and international, as well as monetary and currency arrangements in emerging markets.

Official Financial Support

The main idea behind initiatives concerning official financial support is the need for the function of lending of last resort at the international level. The cleanest case for such an initiative is that in which crises in emerging markets result from a sudden lack of liquidity, i.e., liquidity crises. Liquidity crises are usually addressed through the provision of last-resort lending. In fact, simply the existence of such a lender may be sufficient to prevent destructive runs and panics. The basic argument for international versions of a lender of last resort is the same argument used in a domestic context: by promising in advance to provide financial support in case of unexpected need in which fundamentals are right or will be right, (liquidity) crises are prevented. In fact, financial panic rationalized by the damage in fundamentals that a massive financial withdrawal (a “run”) would generate cannot exist when there is a commitment of ample support that would avoid such damage.

We have argued in Fernandez-Arias and Hausmann (1999) that liquidity crises have been prevalent in recent crisis episodes, which would explain the unpredictability of the collapse in fundamentals, and is a key problem to address for the future. From this point of view, a central problem in the world may be that the globalization of financial flows in the context of original sin (i.e. the inability to borrow long term in a country’s own currency) has overwhelmed the capacity of national central banks in emerging countries to credibly provide enough last-resort lending to prevent liquidity crises.

Therefore, to us international lending of last resort suggests itself.

What are the effects of this initiative on other distortions? Successful lending of last resort reduces private default risk, but this is not necessarily a source of moral hazard. This is a legitimate reduction in risk obtained from removing an inefficient risk factor, i.e., the panic equilibrium. This does not open a gap between social and private risks. In fact, lower expected risks will give rise to more capital flows that will be applied efficiently. Therefore, this initiative in the context of liquidity crises would be good all around.

If, on the contrary, a lending of last resort facility is available to insolvent countries, i.e. countries unable to pay even after all liquidity constraints are removed, then the crisis will not be avoided and the facility may incur losses. Moreover, critics who argue that the recent financial turmoil is not associated with liquidity crises think that the provision of last-resort lending would only serve to bail out private creditors, exacerbating moral hazard problems and thereby aggravating rather than resolving the situation.

It is worth keeping in mind this distinction between liquidity and solvency crises, which is key for the evaluation of this and other initiatives (for a formal analytical framework see Fernandez-Arias 1995). We begin by analyzing the liquidity crisis case, which is the central case in our diagnosis, and then discuss the solvency crisis case.

4Lending of Last Resort

Lending of last resort would be perfect in liquidity crises. The challenge then is to recreate the function of lending of last resort at an international level in the real world.

The obvious move is to create a global lender of last resort or, more specifically, to reform the IMF so that it could better play this role. Making the IMF a global lender of last resort is an idea that was discussed at the time of the Bretton Woods conference in

1944. In spite of the eloquence of John Maynard Keynes, the American representatives were not willing to provide the institution with the ability to print money. After all, the world was adopting a dollar standard and the United States was not about to renounce sovereignty over the management of its own currency.

Since then the political-economy problems of providing a global lender of last resort have been insurmountable, but for other reasons. First, there is reticence to create a powerful global institution that may not be fully accountable. Second, there is the fear that taxpayers in industrial countries would be asked to pay for bailouts in emerging countries. These fears could probably be addressed through the right governance structure and the use of collateral to protect taxpayers from undue risk, although in the international context collateral always remains limited by sovereign risk. The idea has gained the support of Stanley Fischer (1999), the second in command at the IMF.

However, as The Economist (1999) concluded in its recent review of global architectural initiatives, there is very little support for anything this ambitious at the global level. But we must remember that appetites may change as the costs of the alternatives become more obvious.

A second best is to mimic last-resort lending by using extant institutions. In the absence of a global lender of last resort, the IMF and the other International Financial Institutions (IFIs) face a daunting task in dealing with potential liquidity crises. 3 Current rescue packages may not be adequate because, unlike last-resort lending, they are not committed ex ante but are negotiated after a crisis has occurred. In fact, to a large extent the debate has moved towards crisis prevention and lending of last resort because of the dissatisfaction with crisis resolution through rescue packages tried in recent crises. It is useful to recapitulate the reasons why rescue packages had problems in order to discuss the advantages of an alternative facility closer to the idea of last resort lending.

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