Making global markets safer: the latest stirrings from the International Monetary Fund.

• Author: Hausler, Gerd

A key objective of the International Monetary Fund is to increase the benefits that countries can derive from access to an open and deep global financial system. A recent slowdown notwithstanding, the marked increase in capital flows to emerging markets through the 1990s (see Table 1) has increased the importance of reducing vulnerabilities and risks of financial turbulence, as well as costs of resolving financial crises when they occur. While this objective is shared by various national and international bodies with an interest in the oversight and functioning of the global financial system, it goes to the heart of the IMF's mandate. It is therefore worth asking, how has the nature of recent financial crises affected the work of the Fund?

Financial globalization has brought considerable benefits to national economies and to investors and savers. At the same time, however, in a world economy that is increasingly characterized by integrated capital markets and external openness, the IMF has faced capital account and financial crises that were different from the crises of earlier periods. Think of the Latin American debt crisis in the 1980s; the ERM crisis in the early 1990s; the Mexican crisis in 1994; the Asian crisis in 1997; the Russian crisis in 1998; and the recent turbulence in Turkey and in Latin America. The experience suggests that future crises may well have some or all of the following characteristics:

* The private sector as the source of the problem as opposed to the sovereign. Traditional Fund lending against balance of payments disequilibria typically focused on a "twin imbalance" of an external current account deficit, most commonly driven by a fiscal deficit. However, during the Asian crisis, governments generally did not face large borrowing requirements--indeed many were in surplus--and were not a direct source of financial imbalance. Instead, surges in capital inflows reflected dissaving and rising indebtedness of the private sector (see Figure 1).

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* Poor sequencing of financial reform by opening capital accounts before adequately strengthening the domestic financial system. Financial liberalization and open capital accounts, when set against weak regulatory structures, can lead to wrong incentives and create a build-up of macroeconomic vulnerabilities. Indeed, large capital inflows--when intermediated through weak and poorly supervised domestic banks--have created distortions in local asset and credit markets. Foreign borrowing channeled through domestic banking systems, as occurred in Korea, the Philippines, and Thailand, encouraged rapid credit expansion and sharp increases in domestic asset prices (real estate and equities). Incentives to banks and depositors were distorted by implicit or explicit guarantees and weak oversight, and banks lent sizeable amounts to real estate and to marginal corporations, leaving them weak and vulnerable to shocks.

* Fixed exchange rates contributing to a build-up in vulnerabilities, and in some cases a shift in liabilities from the private to the public sector. Whether de facto or de jure, exchange rate inflexibility prior to recent crises gave the wrong incentives by distorting price signals, contributing further to a build-up in vulnerabilities. Fixed rates made uncovered foreign exchange-denominated borrowing in international markets appear less expensive than borrowing in local currency, since the government seemed to be prepared to guarantee the rate of exchange to domestic currencies. Once exchange rates came under pressure and had to be devalued, and then were left to float, private corporations, especially in Indonesia and Thailand, found themselves suddenly insolvent. Although in many cases banks were hedged on paper, the corporate defaults on domestic dollar-denominated loans left the banks unable to cover their dollar deposits. Ultimately, external overborrowing and currency risk shifted from the corporate sector to banks (which faced loan defaults) and then to the government (sharing in the recapitalization of now-insolvent banks).

* Systemic financial crisis. Managing recent crises involved resolving and stabilizing the domestic banking systems and, in several cases, restructuring corporations. Governments in some cases had to grapple with systemic financial crises, marked by severe disruptions of financial markets and market infrastructure, including the payments system. Restructuring corporations and facilitating debtor-creditor negotiations among banks, corporations, and international lenders became an integral part of Fund programs in Indonesia and elsewhere. As well, in some cases large government debt holdings by domestic financial institutions destabilized the domestic financial system when sovereign debt levels became unsustainable and may have complicated resolving the situation.

It is also the case that several factors have combined to increase the severity of financial crises and their social and economic costs.

First, the speed of adjustment differs between financial and nonfinancial markets, making onset of a capital account-driven crisis much swifter and deeper. For example, while the external current account balance typically adjusts over several quarters, the capital account can adjust almost overnight. This often results in overshooting which magnifies the impact that financial developments have on the real economy. Capital inflows can stop suddenly and even reverse. With open capital accounts, residents may add fuel to the fire by freely switching from holding domestic assets (such as deposits in local banks) to foreign assets (deposits in banks located abroad). For instance, during the Mexican crisis of 1994-95, there was a reversal of capital flows equal to 12 percent of GDP, and equal to 15 percent and 9 percent in Thailand and Korea, respectively, over 1996-97 (see Figure 2). Also troublesome in some cases has been a withdrawal of trade financing, which has curtailed exports and added further to the severity of output contraction and unemployment.

Second, the impact on private domestic and sovereign balance sheets of exchange rate depreciation can turn a liquidity...