CHAPTER 4 Reform of the Global Financial Architecture
- International Monetary Fund
- Published Date:
- September 2000
The Committee’s deliberations have taken place today against the background of a growing public debate about the directions in which the IMF and the international financial system should evolve to adapt to a rapidly changing economic environment. The debate also reflects a concern that the benefits the world economy is deriving from freer trade and more integrated and deeper international capital markets are not reaching everyone, especially in the developing countries. The Committee reaffirms its strong support for the IMF’s unique role as the cornerstone of the international monetary and financial system and its ability, by virtue of its universal character, to help all of its members. With the support of all its members, the IMF has undergone continuous change to equip itself better to assist members to build the strong macroeconomic and institutional underpinnings required for international financial stability and the broader sharing of the benefits and opportunities of an open world economy. But more needs to be done, and the Committee therefore pledges to continue to work toward making the IMF more effective, transparent, and accountable.
–Communiqué of the International Monetary and Financial Committee, April 16, 2000
The financial crises of the 1990s exposed weaknesses in the international monetary and financial system, underscoring that globalization entails risks as well as potentially substantial benefits. The international community has also had to deal with the challenges of helping countries in transition from central planning to market economies, and of promoting growth and reducing poverty in the poorest countries. In response, it has mobilized to reform the system’s “architecture”—that is, the institutions, markets, rules of the game, and practices that governments, businesses, and individuals use to carry out economic and financial activities. A strengthened architecture, in turn, helps make the global economy less vulnerable to damaging financial crises, and enhances prospects for all countries to reap the benefits of globalization through improved growth prospects and reduced poverty (see Box 4.1).
While the effort to reform the financial system, including the IMF, is a longer-term one, by the end of April 2000 substantial progress had been made. In several areas—such as increasing transparency and accountability, assessing observance of standards and codes, and better identifying financial sector vulnerabilities–experimental pilot programs were under way, designed to set the stage for decisions on longer-term action. Work on developing and spreading standards to guide member policies was increasingly focused on promoting implementation with the help of IMF technical assistance, and work was under way to develop better analytical tools and data for assessing vulnerability. In other areas—such as capital account liberalization, exchange rate systems, and involving the private sector in crisis resolution—progress had been made on developing workable recommendations, and discussions were continuing.
The IMF’s efforts in FY2000 were part of a coordinated and comprehensive response from the international community. Many institutions and forums are playing key roles in efforts to strengthen the international financial architecture—including the World Bank, the Financial Stability Forum (FSF), the Bank for International Settlements (BIS), other Basel-based groups, the Group of Twenty (G-20)1 and the Organization for Economic Cooperation and Development (OECD). In addition, the efforts of such standard-setting bodies as the International Organization of Securities Commissions (IOSCO), the International Association of Insurance Supervisors (IAIS), the International Accounting Standards Committee (IASC), the International Federation of Accountants (IFAC), and others—and of such forums as the United Nations Commission of International Trade Law (UNCITRAL)–have become increasingly important given the heightened focus on assessment of financial stability and on standards.
Box 4.1Globalization: Threat or Opportunity?
The term “globalization” has acquired considerable emotive force. Some view it as a process that is beneficial—a key to future world economic development—as well as inevitable and irreversible. Others regard it with hostility, even fear, believing it increases inequality within and between nations, threatens employment and living standards, and thwarts social progress.
In reality, globalization offers extensive opportunities for truly worldwide development but it is not progressing evenly. Some countries are becoming integrated into the global economy more quickly than others. Countries that have been able to integrate are seeing faster growth and reduced poverty. Outward-oriented policies brought dynamism and greater prosperity to much of East Asia, one of the poorest areas of the world 40 years ago. And as living standards rose, it became possible to make progress on democracy and on such issues as the environment and work standards.
What Is Globalization?
“Globalization” in its economic aspect refers to the increasing integration of economies around the world, particularly through trade and financial flows. The term sometimes also refers to the movement of people (labor) and knowledge (technology) across international borders.
At its most basic, there is nothing mysterious about globalization. The term has come into common usage since the 1980s, reflecting technological advances that have made it easier and quicker to complete international transactions—both trade and financial flows. It refers to an extension beyond national borders of the same market forces that have operated for centuries at all levels of human economic activity–village markets, urban industries, or financial centers.
Markets promote efficiency through competition and the division of labor—the specialization that allows people and economies to focus on what they do best. Global markets offer greater opportunity for people to tap into more and larger markets around the world. It means that they can have access to more capital flows, technology, cheaper imports, and larger export markets. But markets do not necessarily ensure that the benefits of increased efficiency are shared by all. Countries should be prepared to embrace the policies needed both for the country to benefit from globalization and to ensure that its benefits are shared fairly. The poorest countries, and others, may need the support of the international community as they do so.
Are Periodic Crises an Inevitable Consequence of Globalization?
The succession of crises in the 1990s—Mexico, Thailand, Indonesia, Korea, Russia, and Brazil—suggested to some that financial crises are a direct and inevitable result of globalization. Indeed, one question that arises in both advanced and emerging market economies is whether globalization makes economic management more difficult.
Clearly the crises would not have developed as they did without exposure to global capital markets. But neither could most of these countries have achieved their impressive growth records without those financial flows.
These were complex crises, resulting from an interaction of shortcomings in national policy and the international financial system. Individual governments and the international community as a whole are taking steps to reduce the risk of such crises in the future.
At the national level, even though several of the countries had impressive records of economic performance, they were not fully prepared to withstand the potential shocks that could come through the international markets. Macroeconomic stability, financial sector soundness, open economies, transparency, and good governance are all essential for countries participating in the global markets. Each of the countries came up short in one or more respects.
At the international level, several important lines of defense against crisis were breached. Investors did not appraise risks adequately. Regulators and supervisors in the major financial centers did not monitor developments sufficiently closely. And not enough information was available about some international investors. The result was that markets were prone to “herd behavior”—sudden shifts of investor sentiment and the rapid movement of capital, especially short-term finance, into and out of countries. The international community is responding to the global dimensions of the crisis through a continuing effort to strengthen the architecture of the international monetary and financial system. The broad aim is for markets to operate with more transparency, equity, and efficiency.
That the income gap between high income and low-income countries has grown wider is a matter for concern. But it is wrong to jump to the conclusion that nothing can be done to improve the situation. To the contrary: low-income countries have not been able to integrate with the global economy as quickly as others, partly because of their chosen policies and partly because of factors outside their control. No country, least of all the poorest, can afford to remain isolated from the world economy. Every country should seek to reduce poverty. The international community should endeavor—by strengthening the international financial system, through trade, and through aid—to help the poorest countries integrate into the world economy, grow more rapidly, and reduce poverty. That is the way to ensure all people in all countries have access to the benefits of globalization.
For more on globalization, see IMF Issues Brief, “Globalization: Threat or Opportunity?” April 2000, on the IMF website.
Much of the work on reforming the global architecture will be integrated in the context of IMF surveillance (see Chapters 2–3), which poses new challenges for the IMF, especially on how to draw on the expertise of other institutions in its surveillance. At its April 2000 meeting, the International Monetary and Financial Committee encouraged the Executive Board to continue examining how to incorporate into surveillance the various “architecture” initiatives and asked for a status update at its September 2000 meeting.
This chapter describes the progress made on key elements of a strengthened financial architecture as of the end of April 2000. Detailed and up-to-date information on the range of initiatives can be found on the IMF website.
Transparency and Accountability
Improved provision of information to the markets and the broader public is a central element of the reform of the international financial system. It is also a cornerstone of the IMF reforms put in place in the past few years—and planned for the future.
Transparency, on the part of IMF member countries and the IMF itself, helps foster better economic performance in several ways. Greater openness by member countries encourages more widespread analysis of their policies by the public; enhances the accountability of policymakers and the credibility of policies; and critically informs financial markets so they can operate in an orderly and efficient manner. Greater openness and clarity by the IMF about its own policies, and the advice it gives members, contributes to a more informed debate on policy and to a better understanding of the IMF’s role and operations. By exposing its advice to public scrutiny and debate, the IMF can also help raise the level of its analysis.
The IMF’s Executive Board has adopted a series of measures aimed at improving the transparency of members’ policies and data, and at enhancing the IMF’s own external communications (see also Appendix V). In taking these steps, the Board has been sensitive to balancing the IMF’s responsibility to oversee the international monetary system with its role as a confidential advisor to its members.
As of April 30, 2000, the Executive Board had agreed to:
Make available more information about IMF surveillance of members
- About 80 percent of member countries choose to publish Public Information Notices (PINs) following their country (Article IV) consultations.
- Sixty member countries have agreed to participate in the pilot program for the voluntary release of Article IV staff reports begun in April 1999.
Make available more information on countries’ IMF supported programs
- Letters of Intent and other country program documents are being released for most countries’ requests for, and reviews of, the use of IMF resources (or financing).
- Statements by the IMF’s Chairman of the Board are being issued in News Briefs and Press Releases on the Board’s discussions of requests for the use of IMF resources and reviews.
Carry out internal and external evaluations of IMF practices
- The internal and external evaluations of the Enhanced Structural Adjustment Facility (ESAF), the IMF’s concessional lending facility (now the Poverty Reduction and Growth Facility)–and the solicited public comments on the tentative conclusions of these studies—were published.
- Further internal and external evaluations of IMF operations have been conducted and published, including the External Evaluation of IMF Surveillance, in September 1999, and the External Evaluation of IMF Research Activities, in March 2000. In April 2000, the Board agreed to establish an independent evaluation office in the IMF, the modalities for which will be determined in FY2001. (see Chapter 3.)
Continue dialogue and consultation with the public on IMF activities
- The IMF has carried out, in conjunction with the World Bank, consultations with nongovernmental organizations (NGOs), other members of civil society, and the public at large, as part of the comprehensive review of the Heavily Indebted Poor Countries Initiative (HIPC Initiative), and incorporated their views into the enhanced HIPC Initiative announced in September 1999 (see Chapter 5).
- Also in conjunction with the World Bank, the IMF is releasing to the public IMF policy and country documents under the HIPC Initiative and, in the future, will make available staff assessments of members’ Poverty Reduction Strategy Papers.
- Key internal reports on IMF policies and operations are being released, including papers and Board discussions on the Asian financial crisis and the link between debt relief and poverty reduction.
- Periodic summaries of the Executive Board’s work program and a wide range of policy documents are also being released.
- Preliminary standards and codes are being posted for public comment.
Release more financial information about the IMF
- The IMF posts on its website “Members’ Accounts in the IMF,” which provide timely information on every member country’s financial position with the IMF.
- A new website section, “IMF Financial Activities,” updated weekly, provides key IMF financial statistics, including lending, resources, arrears, and IMF rates; tables on current financial arrangements with members; and the status of commitments to members under the HIPC Initiative.
- Information on the IMF’s liquidity position is posted.
- The Board decided in March 2000 to post the outcome of the IMF’s quarterly financial transactions plan (formerly called the operational budget), which gives information on the sources of financing for IMF lending.
- Public access to the IMF’s archives has been expanded substantially.
The commitment to increased transparency has also led to measures to better explain the IMF’s work to the wider community. Steps have been taken to provide more information to the media and to the public, notably through the IMF website. Further efforts are being made to reach out to civil society, strengthen the IMF’s publications program, and increase dialogue with the private financial sector. In addition, the IMF has implemented a number of elements of a strategy for strengthening its external communications, based on reviews by external consultants (see Appendix V).
In its April 16, 2000, communique, the International Monetary and Financial Committee reiterated the importance it attaches to greater transparency in policymaking in improving the functioning of national economies as well as the international financial system. It underscored as well the importance of enhanced transparency and accountability of the international financial institutions themselves. The Committee welcomed continuing progress in a number of areas, and encouraged further actions to make the policies of the IMF, and of its members, more transparent, without compromising the IMF’s role as confidential advisor
Developing Standards, Principles, and Guidelines
Executive Board discussions on strengthening the international financial architecture have stressed the need to develop and implement internationally recognized standards and codes of good practice. Adopting such standards in areas central to economic and financial system stability can contribute to better-informed lending and investment decisions, increased accountability of economic policymakers and private sector decision makers, and improved economic performance.
Following the development of standards in areas of direct operational concern to the IMF—data dissemination transparency of fiscal, monetary, and financial policies; and banking supervision—efforts have focused on disseminating and implementing these standards, including by providing technical assistance. Material has been prepared to help countries implement the standards: A manual for the Code of Good Practices on Fiscal Transparency has been available on the IMF website since 1998, and the IMF is finalizing a supporting document to the Code of Good Practices on Transparency in Monetary and Financial Policies, which was adopted by the IMFC in September 1999. The operational guidelines for the data template on international reserves and foreign currency liquidity for the Special Data Dissemination Standard (SDDS) will be finalized by the end of 2000, after taking into account members’ experience with its implementation.
The experience with standards must also be reviewed periodically to ensure that their design and implementation remain appropriate. During the financial year, the Board reviewed the experience with the SDDS and the General Data Dissemination System (GDDS) and agreed to changes in the areas of international reserves and external debt.
The Executive Board established the Special Data Dissemination Standard in March 1996 and the General Data Dissemination System in December 1997. The SDDS aims to guide countries that have, or seek, access to international financial markets in disseminating economic and financial data to the public. The GDDS is targeted at countries not yet able to subscribe to the SDDS but which seek to improve their statistical systems. It emphasizes the development of sound statistical systems as preparation for the timely dissemination of data to the public.
In March 2000, the Executive Board concluded a third review of the IMF’s data standards initiatives, citing substantial progress in meeting the requirements of the SDDS. Most subscribers were expected to be fully observing the requirements of the SDDS by the end of June 2000, and systematic monitoring of observance of the standard would begin at that time. The GDDS was moving into its operational phase.
Among the conclusions of the Board review were the following:
- To strengthen the provision of data for assessing external vulnerability, a standard format for disseminating data on official reserves and foreign exchange liquidity will be used, based on the SDDS reserves template approved in 1999. Template data will be distributed in this format on the IMF’s website.
- A separate SDDS data category for external debt statistics will be introduced; it will involve the dissemination of comprehensive and timely data broken down by major sectors on a quarterly basis. This will be phased in over three years.
- The GDDS will also be enhanced with respect to external debt, with public and publicly guaranteed debt and the associated debt-service schedule in the core data categories of the GDDS.
- As to data quality, IMF staff is extending earlier work on a framework for assessing quality more systematically. In addition, a Data Quality Reference Site was established on the Dissemination Standards Bulletin Board (www.dsbb.imf.org) to foster a common understanding of data quality, drawing on contributions from the international statistical community.
Box 4.2Experimental Assessments of the Observance of Standards
The IMF and World Bank have developed an organizing framework to assess the observance of standards in cooperation with national authorities and other international bodies. Assessments are prepared using a range of different instruments.
- The joint IMF–World Bank pilot Financial Sector Assessment Program (FSAP) is focused mainly on assessing financial sector vulnerabilities and identifying developmental priorities. This involves, in part, assessing those financial sector standards that are key to stability in each particular case. All FSAPs assess compliance with the Monetary and Financial Policy Transparency Code and the Basel Core Principles. The FSAP is a collaborative effort involving expert support by a range of national agencies and standard-setting bodies.
- Adherence to standards on data dissemination and fiscal transparency is assessed in connection with the IMF’s technical assistance activities and in stand-alone exercises connected with surveillance and program reviews.
- The World Bank, in cooperation with other bodies, is experimenting with assessments in the areas of corporate governance and accounting and is developing methods of conducting assessments.
The IMF–World Bank Reports on the Observance of Standards and Codes (ROSCs) provide a framework for assembling these assessments. Experimental ROSC “modules” describe country practice in a particular area, along with an assessment of the extent to which practice is consistent with the relevant international standard. At the end of FY2000, ROSC modules covering 15 industrial, emerging market, and developing economies were completed by IMF staff in cooperation with national authorities for countries that had volunteered to join in the pilot program, and modules were being prepared for another 18 countries. World Bank staff plan to prepare about six corporate governance modules by mid-2000, and about the same number of accounting modules by the end of September 2000. Publication of the ROSCs remains at the discretion of national governments, although most completed assessments have been made available on the IMF website.
Self-assessments of the observance of standards complement external assessments. Self-assessments can help promote ownership by national authorities, and, if based on clear and well-developed methodologies, use scarce international resources more effectively. Without external assessments, however, self-assessment may lack credibility and rigor. Clear “how to” manuals are critical to guide selfassessments, ensure complementarity between self-assessments and outside assessments, and promote comparability across jurisdictions. Greater international support for efforts by standard-setting bodies to develop methodologies would help encourage the adoption of standards. Market and official incentives could also boost the commitment of countries to implement and observe standards.
The Board asked the staff to issue a new quarterly report on the SDDS to increase awareness of progress being made and to give the initiative more prominence. It also asked the staff to explore ways to include references to countries’ subscription to the SDDS in country surveillance staff reports and PINs, including how observance should be discussed.
While adopting any individual standard is voluntary, the international community has also recognized the importance of information on the extent to which countries comply with internationally recognized standards and codes. The IMFC has agreed that country (Article IV) consultations provide the right framework within which to organize and discuss with national authorities the implications of assessments of compliance with standards and codes. How this work will best be incorporated into IMF surveillance remains to be decided. Support for these “transparency reports”—now referred to as Reports on the Observance of Standards and Codes (ROSCs)—has nonetheless been wide-ranging, and an experimental program has been under way since early 1999 (see Box 4.2)2
There is a critical distinction, however, between undertaking assessments of a member’s observance of particular standards and using those assessments in IMF surveillance. The former requires detailed knowledge of the relevant standards and the expertise to use this information to benchmark individual country practices. The latter involves an appreciation of how these practices have been changing over time and how they affect economic and financial system stability.
The Board has stressed that, in undertaking assessments, staff should concentrate mainly on areas within the IMF’s direct operational focus—that is, fiscal and monetary transparency, financial sector soundness, and data dissemination. Directors have also emphasized the importance of assessing standards in other areas—with these assessments drawing on the skills of other expert bodies. To this end, the Board endorsed a shared ownership approach to preparing ROSCs. Under this approach, different international institutions take primary responsibility for assessments in different areas, in line with their mandates and expertise. The World Bank has agreed to join the IMF in co-preparing ROSCs and is experimenting with assessments in corporate governance and accounting.
Even working jointly, there are limits to what standards the IMF and World Bank can assess. Other international financial organizations, standard-setting bodies, and national authorities all have roles to play, and mechanisms need to be developed to involve them. In this regard, the pilot project of the joint World Bank-IMF Financial Sector Assessment Program has been particularly effective in bringing the expertise of national agencies and standard-setting bodies to the assessment process (see the discussion on “Strengthening Financial Systems” below).
Country (Article IV) surveillance provides the appropriate framework within which to organize and discuss the implications of assessments with national authorities, although the methods for doing so remain experimental during the period of the ROSC pilot. In addition, linking the monitoring of standards and codes to the country consultation process—with its near universal coverage and uniformity of treatment—ensures a continued focus on promoting standards. A comprehensive range of assessments will also be valuable for the World Bank’s work in helping countries determine reform and development priorities. Similarly, feedback from assessments can help standard-setters identify the strengths and weaknesses in existing standards and guide future work. If assessments are published, they would also help markets make better informed lending and investment decisions. This should, in turn, encourage greater efforts to carry out and adhere to standards.
Strengthening Financial Systems
Recent episodes of financial crises in a number of countries, and cross-border “financial contagion,” have underscored the importance of sound financial systems in member countries, and particularly the need to better identify financial sector risks and vulnerabilities at an early stage (see Box 4.3 for a review of the Board discussion on lessons for financial sector restructuring of the Asian financial crises). Banks and other financial institutions need to improve such internal practices as risk assessment and management, and the official sector must upgrade its supervision and regulation of the financial sector to keep pace with the modern global economy.
Although the IMF has, for some time, given prominence to covering and assessing financial sector soundness in its surveillance and lending activities, deeper and more focused analysis in this area is needed. Priorities are to examine the health of financial sectors systematically and to identify the linkages among macroeconomic policies, the real economy, and structural and developmental issues in the financial sector. To do this work most effectively, and to use scarce expert resources efficiently, the IMF is collaborating with the World Bank
The IMF–World Bank Financial Sector Assessment Program (FSAP)–introduced as a one-year pilot in May 1999–has been the core instrument for more focused financial sector analysis. The program aims to underpin a more effective dialogue with national governments, to help countries reduce vulnerabilities in their financial sectors, and to help decide priorities for financial sector development. To increase collaboration and consistency in policy advice between the IMF and the Bank on financial sector work, and to better coordinate technical assistance, a Financial Sector Liaison Committee (FSLC) has been operating since late 1998.
Within the IMF, staff prepare Financial System Stability Assessments (FSSAs)—with a focus on vulnerability issues—based on the Financial Sector Assessment Program reports for each country. Staff assessments of risks to the macroeconomy from the financial sector are brought into the country consultation process and are used in IMF program design.
The Financial Sector Assessment Program pilot was well under way by the end of FY2000. Of the planned pilot assessments for 12 countries—covering a range of financial systems and geographic regions–4 had been completed and 8 were in progress. Owing to the resource-intensive nature of the program, the specialized skills needed, and the limited staff resources in the World Bank and the IMF, national central banks and supervisory agencies, as well as international standard setting bodies, have been invited to provide experts to contribute to the assessments of individual countries. Feedback so far from national governments has been positive and their suggestions for improvements are helping refine the program.
Box 4.3Lessons from the Asian Financial Crisis
Executive Directors discussed in early September 1999 the lessons for financial sector restructuring from the Asian crisis. In the most affected countries—Indonesia, Korea, and Thailand—financial sector reforms were at the core of IMF-supported programs. The crisis originated in a combination—in differing proportions across countries—of financial and corporate sector weaknesses and macroeconomic vulnerabilities. A key source of vulnerability had been the large capital inflows in the earlier part of the 1990s, particularly, unhedged short-term foreign borrowing. This had made the three crisis countries vulnerable to capital outflows and exchange rate depreciations. Capital inflows had also fueled a rapid credit expansion that led to asset price inflation and financing of low quality investments. The credit expansion also reflected weaknesses in lending practices, ineffective market discipline, deficiencies in prudential regulation and supervision, and, in some countries, the close links among governments, banks, and corporations. The banking crisis was further deepened by weaknesses in the corporate sector, which, in some countries, was highly leveraged. Many Directors suggested that pegged exchange rate regimes and implicit guarantees were also leading sources of vulnerability, because they induced investors to ignore the foreign currency risks, thereby increasing unhedged external borrowing and maturity mismatches in banks’ portfolios. Those measures had also undermined the incentives to implement efficient prudential rules on foreign exchange exposures.
Once market sentiment had changed, the size and speed of the impact on the financial systems were unprecedented and required substantial and far-reaching government intervention. The Asian crisis had thus highlighted the close linkage between financial sector soundness and macroeconomic stability.
Directors supported the measures taken by the national authorities to address the emergency and stabilize their financial systems. The experience showed the importance of explaining measures clearly to the public and implementing them as a package to reassure the markets of the government’s determination to address the crisis.
In summing up lessons from the Asian crisis for the IMF, Directors highlighted the following:
- “Ownership” of IMF-supported programs by governments is critical for the success of the reform process. The IMF should help countries achieve effective ownership and gain public support for the envisaged reforms.
- Transparent information and rules, regulations, and administrative procedures can help prevent or lessen the impact of financial crises and facilitate IMF surveillance. At the same time, market participants must use the available information to guide their investment decisions.
- Surveillance over financial and corporate sectors is important and should focus on identifying vulnerabilities, assessing the quality of policies, and ensuring transparency of information and regulations.
- Prompt and decisive action to deal with banking problems is also important. Preparation should include contingency plans to address potential financial sector difficulties. Specific measures to reduce the possibility and impact of any future crisis should be examined; these could include the adoption of countercyclical prudential policies. Directors cautioned, however, that such policies should not be part of demand management or an excuse for forbearance.
- The IMF’s role in dealing with crises—which increasingly have had financial sector turmoil as a major ingredient—points to the need to develop further IMF conditionality and policies to deal with financial sector issues, in close collaboration with the World Bank. To be effective, reform programs should be designed to convince markets that they will be implemented successfully. In this regard, many Directors stressed the need for appropriate sequencing and for setting realistic targets and timetables. The management of these crises has also required intensive technical assistance from the IMF and from other institutions, particularly the World Bank and Asian Development Bank. The IMF therefore needs to have expertise and human resources to support members, especially in developing robust financial systems and in managing financial crises.
In March–April 2000, the Executive Boards of the IMF and World Bank discussed a progress report on the Financial Sector Assessment pilot (see Box 4.4). On the basis of the experience gained with the pilot, both Boards agreed to continue the program. The pace of country coverage is expected to pick up to 24 countries in FY2001.
External Vulnerability and Capital Flows
Countries can benefit substantially from capital account liberalization, if liberalization is properly sequenced and managed. IMF surveillance aims to assess risks and vulnerabilities at both the national and international level. Timely, frequent, and high-quality data are critical for an effective assessment. With the benefit of hindsight, limitation on the availability of such data delayed the early detection of some of the strains that led to the emerging market financial crises and worsened the difficulties in fashioning a timely policy response. As a result, much effort is being focused on how to improve both data quality and reporting and the use of vulnerability indicators in conjunction with standard economic analysis.
Work to develop better methods for evaluating external vulnerability has advanced on several fronts in the IMF (see Box 4.5), World Bank, and in other international institutions. The increased emphasis on the dissemination of comprehensive and timely data on external debt and official reserves under the SDDS is discussed above. Work to make data on external debt and foreign exchange liquidity more available is also under way in other forums. The IMF-chaired Inter-Agency Task Force on Finance Statistics3 has kept a quarterly database of creditor-side data on external debt on the Internet since March 1999. The Task Force is working to increase the timeliness and coverage of these data. The BIS has announced several initiatives to heighten the coverage and analytical usefulness of its international banking statistics. The Financial Stability Forum Working Group on Capital Flows has recommended improvements in data from national, creditor, and market sources. Western Hemisphere finance ministers have called on interested participants to prepare discussion papers on their debt and fiscal management policies and have asked the Inter- American Development Bank, IMF, and World Bank to host a seminar to discuss these papers in FY2001.
Box 4.4Progress Review of the Pilot Financial Sector Assessment Program: Key Conclusions
The FSAP has helped country authorities identify areas needing strengthening and guided the adoption and sequencing of necessary reforms. In some cases, it has spurred officials to focus attention on significant financial system issues earlier, and in more depth, than otherwise.
At the same time, the FSAP can be improved further. The linkages between macroeconomic and structural conditions and developments need to be better understood. To this end, the research agenda on financial stability and structural issues must be given a high priority. Even greater emphasis on focusing individual assessments as early as possible on the key financial issues for each case will help make most efficient use of the staff resources of both national governments and FSAP missions.
Carrying out the FSAP has required capacity building in the IMF and World Bank. Staff skills in both institutions are being strengthened, particularly in the areas of analytical methods and techniques to assess the health of financial institutions and financial sectors as a whole. In this connection, attention is being paid to stress test methodologies and developments of macroprudential indicators.
The participation of staff from national authorities and other standard-setting bodies provided a valuable contribution to the FSAP pilot, particularly in the areas of supervision and payment systems. Outside participation brought in important specialized expertise and an element of peer review, thereby increasing the credibility and acceptance of the assessments.
In response to a request from the Financial Stability Forum Working Group on Capital Flows, the IMF hosted a conference on capital flow and external debt data in February 2000. The conference brought together a wide range of data users in the public and private sectors and data compilers for an exchange of views on how to produce better and more timely data on debt and capital flows. Views among participants on directions for future work differed widely, although all considered that initiatives to date to promote methodological and data dissemination standards had been useful. (The agenda, background material, and a summary of the conference are posted on the IMF’s website.)
The IMF and World Bank are collaborating on a series of papers on external debt management. Drawing on research at the World Bank, the IMF, and elsewhere, staff have undertaken work on debt- and reserve related indicators of external vulnerability, which considers the analytical usefulness of various indicators and the scope for the derivation of simple benchmarks (such as threshold levels for certain indicators) to better gauge countries’ abilities to withstand external shocks. Also in preparation are a study on sound practices in sovereign debt management, a set of guidelines on sovereign debt management, and a manual for developing domestic capital markets.
In other related areas:
- The Board held a number of discussions in FY2000 that dealt with structural and institutional elements in the management of foreign exchange reserves. The results of these discussions will feed into IMF surveillance, financing, and technical assistance activities.
- With IMF support, systems for high-frequency monitoring of external liabilities of domestic banking systems have been established in a number of countries to improve the authorities’ capacity to detect emerging signs of vulnerability and help in crisis management. The usefulness of these and other systems for high-frequency monitoring of foreign exchange transactions is being assessed by the IMF staff in consultation with member countries.
- The IMF has initiated a project to identify statistical data (referred to as “macroprudential indicators”) needed to support the evaluation of financial systems and to develop strategies to compile the data and encourage their dissemination to the public. A research program has been launched, and the staff is surveying members regarding their needs and practices related to macroprudential indicators. Investigations of data on financial soundness are also being undertaken in conjunction with the joint IMF World Bank Financial Sector Assessment Program.
- The IMF has also joined in efforts to develop early warning systems for external crises—that is, formal models that estimate the probability of crisis from a compact set of variables—to better inform surveillance. The Board has noted that while early warning systems could be a useful additional tool for surveillance, they must be used cautiously. Work is continuing to improve the accuracy of these models and find their most useful applications.
Box 4.5Conference on Reform of the International Monetary and Financial System
In late May 1999, the IMF’s Research Department hosted a conference on the reform of the international monetary system. Participants from academia, the public and private sector, and international financial institutions were invited to take a critical look at issues central to the discussion of how to strengthen the system. These issues covered coping with capital flows, coordinating exchange rate policies, providing financial assistance to countries facing external payment difficulties, and preventing and resolving financial crises.
The main topics of discussion included the exchange rate among major currencies, the exchange rate regime for emerging market economies, analysis of emerging market crises, the role of capital controls, private sector involvement in crisis prevention and resolution, and international official assistance and the role of the IMF.
In summing up the conference, First Deputy Managing Director Stanley Fischer focused on three issues:
- Should capital flows to developing and emerging markets be encouraged, in view of the recent crisis experience? There is a serious and analytically coherent case for freedom of capital account transactions, Fischer said. For one thing, the same analytical apparatus that economists use to justify free trade in goods at a point in time applies to trade in assets over time. Second, although net capital flows may be small relative to either domestic saving or domestic investment they are not necessarily small relative to net investment and can thus make a significant difference to growth. Third, capital account transactions allow for better risk sharing for both lenders and borrowers. Fourth, international capital flows, and direct investment in particular, make for healthy competition for domestic financial institutions and are often accompanied by significant technology transfers. Finally, there appears to be an association between tight controls on capital movements and generally inward-looking anticompetitive national economic structures.This is not to deny there are a number of serious problems associated with capital flows to developing and emerging market economies, including excessive volatility in response to changing market sentiment. In addition, risk often appears not to be priced correctly, as indicated by the behavior of spreads on emerging market debt, signaling the existence of systemic problems. On balance, however, governments have not pulled out of international capital transactions despite the many shortcomings of financial markets. This indicates that the net balance of benefits and costs is, on the whole, perceived to be on the side of remaining open rather than retreating into autarky. It is all the more important to make the world a more stable one and to lessen the dangers countries are subject to when opening up the capital account. In this context, Fischer stated that there was, in some circumstances, a case for market-based controls on short term capital inflows and, certainly, for prudential regulations.
- What is the appropriate exchange rate regime? Among countries facing currency crises, those that had fixed or pegged rates tended to get hit the hardest when they tried to defend their rate or maintain the peg. Countries with floating rates that have suffered speculative attacks in the past seem to have suffered less serious hits. The move toward floating, with prudential controls, will likely continue, although hard currency pegs would also be favored by some countries.
- Can moral hazard be avoided? Moral hazard will always exist. The question to be asked is: How much moral hazard can be contained in a sustainable equilibrium? A crisis is obviously not a sustainable equilibrium, so measures need to be taken to keep moral hazard within permissible limits. The advanced economies should take the lead in implementing changes.
Mr. Fischer concluded by stressing that, as the worst effects of the Asian crisis fade, the international community, far from relaxing its vigilance, is redoubling its efforts to find new and effective means to deal with future crises.
A seminar volume entitled Reforming the International and Monetary System will be published by the IMF.
Work at the IMF and elsewhere on the analytical framework for evaluating external vulnerability underscores the importance of timely information on the external liabilities and foreign exchange exposures of all sectors of the economy, as well as analysis of the risks posed by derivatives exposures and contingent liabilities. In parallel with the effort to develop better information on these sources of vulnerability, further research is under way on how to measure vulnerability from off-balance-sheet operations. The World Bank is also conducting research on issues of corporate sector vulnerabilities.
Capital Account Liberalization and Capital Controls
In several discussions during FY2000, the Executive Board underlined the substantial benefits of capital account liberalization but stressed the need to manage and sequence liberalization carefully to minimize risks
In September 1999, Directors agreed there was no single approach to securing the benefits of international capital flows while limiting the risks. Views continued to differ as to the net benefit or cost of capital controls and, hence, the usefulness of controls. Based on a series of country studies, the following tentative observations could be made:4
- Capital controls cannot substitute for sound macroeconomic policies, although they may provide a breathing space for corrective action. The room for policy maneuver that controls can provide has varied greatly across countries, reflecting a variety of factors including the degree of flexibility in exchange rate policy, the level of financial market development, the quality of prudential policies, and the administrative and enforcement capacities of the authorities. Countries with serious macroeconomic imbalances, and no credible prospects for correction in the short run, however, have regularly been unable to address large-scale capital outflows by using capital controls. Moreover, in some cases, controls have reduced pressures on the authorities to introduce needed policy reform. Some have also pointed to the possible harmful consequences on other countries from the imposition of capital controls.
- Although comprehensive and wide-ranging controls appear more effective than selective controls, they also tend to be more distortionary, impede desirable transactions, dampen financial market development, and adversely affect investor confidence and access to international capital markets. Nonetheless, many Directors believed that controls on capital inflows to supplement other policy measures may be warranted in situations where a country experiences large persistent inflows; thus, the possible benefits of controls had to be weighed carefully against their costs.
- Building effective regulatory and supervisory institutions for financial markets may take a long time. More work is needed, however, to determine whether capital controls—particularly on short-term inflows—may temporarily and partially substitute for full-fledged prudential arrangements.
- Strong prudential policies for the financial sector can play an important role in orderly and sustainable capital account liberalization, and in reducing the vulnerability of an economy to outside shocks. Directors agreed that work in international forums to address potentially destabilizing capital flows should concentrate on efforts to improve prudential regulation and supervision, both in creditor and debtor countries, and aim for coherence in prudential policies among countries.
- A case-by-case approach to capital account liberalization was needed. The sequencing and pace of capital account liberalization, capital account opening, and financial sector reform were ongoing and interrelated processes, which are closely linked to the overall level of economic development and a country’s other individual circumstances.
Discussions will continue on these issues in FY2001. Since the emerging markets crises, the surveillance of capital account developments has been given greater prominence in country consultations. Staff reports have increasingly included discussions of vulnerabilities arising from capital flows. Policy discussions have focused increasingly on the composition of capital flows and capital account regulations. Special attention has been given to risks posed by the potential reversal of capital inflows, the impact of selective capital account liberalization, and the rapid buildup of foreign-currency denominated debt. Looking ahead, Directors saw scope to expand the systematic use of vulnerability indicators in surveillance and to investigate the adequacy of prudential safeguards to ensure that the financial sector and the wider economy are resilient to possible shocks.
Exchange Rate Regimes
The choice of the right exchange rate regime has become ever more important as an increasing number of countries have become more integrated in world capital markets. During the financial year, the Executive Board considered the key issues concerning exchange rate regimes in an environment of increasing international capital mobility. Directors drew the following conclusions:
- No single exchange rate regime is suitable for all countries or in all circumstances. Whatever exchange rate regime is adopted, its consistency with underlying macroeconomic policy is essential.
- The existing system of flexible exchange rates among the three major currencies is likely to continue. Thus, countries need to adapt to a global environment of exchange rate variability. Large misalignments and volatility in major currencies are a cause for concern, particularly for small, open, commodity-exporting countries. IMF surveillance must fully take into account spillover effects of macroeconomic and structural policies in major currency countries.
- In recent years, several emerging market countries have adopted a flexible exchange rate regime. The requirements for upholding a peg when capital is internationally mobile are exacting. Even with flexibility, supporting macroeconomic policies should be coherent and credible; an alternate framework to the peg, such as monetary or inflation targeting, is needed to provide a nominal anchor.
- Large exchange rate swings in small or medium-sized open economies may have significant economic costs. Although exchange rates must be allowed to adjust in response to market pressures, it may also be appropriate to use domestic monetary policy or intervention to limit swings.
- If credible supporting policies and institutions are in place, a peg could still be viable for the smaller, more open economies, especially those less open to short term capital flows or with a dominant trade partner. In particular, very constraining pegs—such as currency boards—can be sustainable when supported by credible macroeconomic policies.
- The IMF should continue to respect the exchange rate regime choices of members, but its surveillance and programs must seek to ensure that countries’ policies and circumstances are consistent with their exchange rate regimes. The IMF should not provide large-scale assistance to countries intervening heavily to support an exchange rate peg if this peg is inconsistent with underlying policies. In some cases, it should offer advice on a suitable exit strategy.
In recent years, the assessment of exchange rate policies in the context of IMF surveillance has been strengthened for most countries, and particularly so for advanced and emerging market economies. Analyses of exchange rate determinants have been deepened, and greater candor in assessments and policy advice is evident. There is scope, however, for further improving the analysis of exchange rate policy issues in developing countries, despite the constraints imposed by data limitations. Looking ahead, efforts are under way to extend to a broader group of members the existing framework used in the analysis of exchange rate behavior and policies in advanced countries.
Involving the Private Sector in Forestalling and Resolving Crises
Involvement of the private sector in the resolution of financial crises5 is appropriate in order to have the burden of crisis resolution shared equitably with the official sector, strengthen market discipline, and thereby increase the efficiency of international capital markets and the ability of emerging market borrowers to protect themselves against volatility and contagion. An additional goal is to avoid moral hazard—the danger that investors’ expectations of international “rescues” encourage risky lending.
Prevention is key. Recent experience has confirmed that consistent macroeconomic and exchange rate policies, sound debt management, and effective prudential supervision of financial systems are all vital to prevent and mitigate the severity of crises. At the same time, policies designed to improve the environment for private sector decision making can also help reduce vulnerability. Improvements in the transparency of both the public and private sectors and efforts to promote the adoption of, and adherence to, standards should facilitate risk management by investors. Country authorities also need to maintain regular contacts with private market participants, to ensure the regular reporting of information on economic developments and policies, and to maintain lines of communication both in good times and when difficulties in the country’s economic situation begin to emerge.
In its discussions during the financial year, the Executive Board noted that the international financial community recognized the need to secure the involvement of the private sector in resolving financial crises. In reviewing recent experience, Directors considered the two cases of efforts to secure private sector involvement with members that had lost spontaneous access to capital markets through the restructuring of international sovereign bonds—Ukraine and Pakistan—had been encouraging. Debt exchanges were arranged successfully and disruptive litigation has not, so far, been a problem. While it was premature to assess whether litigation may eventually become an issue, Directors agreed that the risks of such litigation in cases to date were not as great as previously thought. Successful debt exchanges in these cases involved the recognition by creditors of the limited debt-servicing capacity of the debtors, and of the lack of palatable alternatives. The precise form of the recent debt restructurings depended on the structure of the payments falling due and the particular country circumstances and did not necessarily involve comparable treatment of all debt categories or maturities.
The Board saw merit in continuing to work toward an operational framework for securing private sector involvement, building on the principles articulated by the Group of Seven finance ministers in their report to the Cologne Economic Summit in June 1999 and endorsed by the Interim Committee in their September 1999 Communique. Directors agreed that flexibility was needed in handling individual cases. The form of continued private sector involvement would depend on the circumstances of each case, as would the methods used to ensure it. Private sector involvement in resolving a financial crisis could, in some cases, be achieved mainly on the basis of the IMF’s traditional catalytic role, with the strength of an IMF-supported adjustment program boosting market confidence and leading to the restoration of spontaneous private capital flows. In cases where greater assurance was needed, the catalytic role of the IMF would have to be supplemented by more direct or explicit measures to improve coordination among creditors.
In assessing the appropriate means to secure private sector involvement in individual cases, however, a range of complex issues requiring considerable judgment will have to be addressed. These include the size of financing needs, both during the program period and over the medium term; the prospects for a spontaneous return to capital market access; the availability of tools for securing concerted private sector involvement; and the desirability of minimizing possible spillover effects on other countries.
The basic principles underlying the IMF’s approach to private sector involvement should be to allow the IMF to support effective balance of payments adjustment programs leading to sustained growth and medium-term viability, while safeguarding the revolving character of IMF resources. These principles, in turn, require that programs with member countries be fully financed. In addition, the availability of official financing, as far as possible, should not create moral hazard by providing incentives for inappropriate lending or borrowing.
The Executive Board stressed that, in making operational a framework for private sector involvement:
- contracts should be honored to the extent possible;
- members should seek cooperative solutions to emerging debt difficulties;
- no one category of private creditor should be regarded as inherently privileged relative to others; and
- the approach taken in individual cases should reflect a country’s specific circumstances—including the composition of outstanding debt instruments—and should be based on an analysis of the country’s medium-term balance of payments prospects and debt sustainability.
Executive Directors considered that, in conjunction with these principles, the framework suggested by staff for private sector involvement (outlined below) constituted a useful start. Nonetheless, they pointed to several problems in making the framework operational, including the difficulty of the underlying analytical judgments.
Under the approach discussed by the Board, private sector involvement could be ensured mostly through reliance on the IMF’s traditional catalytic role:
- if the member’s financing needs are moderate; or
- even when the financing needs are large, if the member has good prospects of rapidly regaining market access on suitable terms.
More concerted forms of private sector involvement could be required:
- if the financing need is large and the member has poor prospects of regaining market access in the near future; or
- if the member has a debt burden that appears unsustainable in the medium term.
The IMF’s approach to a given case requires a decision on how much financing the official sector is willing to make available in support of a member’s adjustment program. Most Executive Directors noted that IMF financing beyond that available under the IMF’s access policy was limited and, while the Supplemental Reserve Facility (SRF) was available under specified circumstances, care had to be taken to avoid the impression that the IMF, or the official sector as a whole, would fill all financing gaps. At the same time, the difficulty of determining ex ante the precise distribution between official and private sector financing was noted. Some Directors favored a presumption that private sector involvement would be secured if the IMF’s financing relative to the member’s quota exceeds some limit. Others, however, felt that the size of the financing requirement was only one element in deciding on concerted involvement; they emphasized having a strong program that would assure the rapid restoration of market confidence and limit demands on official resources.
In cases when the IMF’s traditional catalytic role and the assumption about the return to market access proved to be wrong, the risks to the program financing and the IMF’s resources would grow unless there was a switch to more concerted forms of private sector involvement. To justify the strategy of relying on the catalytic role, the member country’s program must be directed to rebuilding market confidence and removing any barriers to the right sort of capital inflows. The government must also be fully committed to sustained implementation. Some Directors felt reduced official financing might be needed in certain cases to ensure proper balance in the contributions of the private and official sectors.
When a member has an unsustainable debt burden, private sector involvement in restructuring or reducing that burden would be required. Determining whether a debt burden is unsustainable is a matter of judgment, and it could take time for the member and its creditors to agree on the extent of the problem and its solution. In such cases, the IMF would be prepared to lend to a member in arrears to its private creditors, as in other cases in which early support for a member’s adjustment program was considered necessary, and provided the member was negotiating with its creditors in good faith.
Where private sector involvement is needed, its precise form will have to be decided case by case. Some Executive Directors considered the approach to be taken in individual cases should seek to avoid prohibitive increases in the future cost of borrowing for the country concerned. Directors believed that, in general, efforts to involve the private sector would be concentrated on the debt payments associated with the immediate financing problem, and would thus not necessarily be comprehensive across all classes of private instruments. Experience suggests, however, that comprehensiveness within an asset class can contribute to a successful outcome. In addition, it is particularly important that no one category of private creditor be seen as inherently privileged.
Only limited progress has been made in lifting institutional constraints to debt restructuring. Directors encouraged the establishment of creditor committees, if needed and on an ad hoc basis, and saw merit in incorporating collective action clauses into international sovereign bond contracts. The inclusion of such clauses in certain U.K. and Canadian sovereign bonds was welcomed, as was the clarification of the status of such clauses by the German government. Directors noted that temporary and voluntary market-based standstill arrangements could be desirable in some circumstances to minimize the risk of disruptive litigation; some believed there should be further consideration of issues related to changing the IMF’s Article VIII, Section 2(b) (which describes members’ obligation to avoid restrictions on current payments).
IMF staff have a role in informing creditors of the status of negotiations between the IMF and the member, and of the member’s economic situation—including its adjustment program and payment capacity—if this is acceptable to the member concerned. Nevertheless, it is important to preserve the principle that the IMF is not a party to the negotiations between a member and its creditors.
In its April 2000 communiqué, the International Monetary and Financial Committee underscored the importance of prevention as the first line of defense against crises and noted that countries participating in international capital markets and their private creditors should seek, in normal times, to establish a strong, continuous dialogue. Collective action clauses could help facilitate orderly crisis resolution.
The Committee noted that the IMF had an important role with regard to crisis resolution and agreed that the approach adopted by the international community should provide for flexibility to address diverse cases within a framework of principles and tools, and be based on the IMF’s assessment of a country’s underlying payment capacity and prospects of regaining market access.
In some cases, the combination of catalytic official financing and policy adjustment should allow the country to regain full market access quickly. In some cases, emphasis should be placed on encouraging voluntary approaches, as needed, to overcome creditor coordination problems. In other cases, the early restoration of full market access on terms consistent with medium-term external sustainability may be judged to be unrealistic, and a broader spectrum of actions by private creditors—including comprehensive debt restructuring—may be warranted to provide for an adequately financed program and a viable medium term payments profile.
In cases where debt restructuring or debt reduction may be necessary, the Committee agreed that IMFsupported programs should emphasize medium-term sustainability and strike an appropriate balance between the contributions of the private external creditors and the official external creditors, in light of financing provided by international financial institutions. The Committee stressed the need to aim for fairness in the treatment of different classes of private creditors, and that no class of creditors should be considered inherently privileged. The IMF should review the country’s efforts to secure needed contributions from private creditors in light of these considerations, as well as medium-term sustainability. The responsibility for negotiation with creditors must be placed squarely with debtor countries. The international financial community should not micromanage the details of any debt restructuring or debt reduction negotiation.
The International Monetary and Financial Committee agreed that the IMF should consider whether private sector involvement was appropriate in programs supported by the IMF. In this regard, the Committee also agreed on the need to provide greater clarity to countries about the terms and conditions of their programs. When all relevant decisions were made, the IMF should set out publicly how and what policy approaches have been adopted.
Reform of IMF Facilities
The Board initiated in FY2000 a review of IMF financial facilities or policies to determine whether and how they need to be modified. The review led to the elimination of four obsolete facilities (and expiration of the temporary Y2000 (Y2K) facility) and consideration of modifications to other nonconcessional facilities (see Chapter 6).
International Monetary and Financial Committee
On September 30, 1999, the IMF’s Board of Governors adopted a resolution approving a proposal of the Executive Board to transform the Interim Committee of the Board of Governors on the International Monetary System into the International Monetary and Financial Committee of the Board of Governors. In addition to the name change, the Board of Governors explicitly provided for preparatory meetings of representatives of the Committee members (deputies). The new Committee continues to advise and report to the Board of Governors with respect to the functions of the Board of Governors in:
- supervising the management and adaptation of the international monetary and financial system, including the continuing operation of the adjustment process, and in this connection reviewing developments in global liquidity and the transfer of real resources to developing countries;
- considering proposals by the Executive Board to amend the Articles of Agreement; and
- dealing with sudden disturbances that might threaten the system.
The members of the International Monetary and Financial Committee reflect the composition of the Executive Board: each country that appoints, and each group that elects, an Executive Director, appoints a member of the Committee.