- International Monetary Fund
- Published Date:
- September 2005
Improving the Policy Response to Financial Crisis
Remarks by Agustín Carstens, Deputy Managing Director, International Monetary Fund at the Bank of Spain and IMF International Conference on Dollars, Debt, and Deficits—60 Years After Bretton Woods
June 14, 2004
It is a pleasure and an honor to have the opportunity to address such a distinguished audience at this international conference that celebrates the 60th anniversary of the creation of the Bretton Woods institutions. At the outset, I would like to thank the Banco de España for its superb hospitality and for the very close collaboration with the IMF in putting all of this together
During the last 60 years, the Fund and its member countries have been struggling with the challenge of improving the policy response to financial crisis. As many of us know quite well, when a crisis occurs, resolution is far from an easy task. Ideally, policy measures will aim to limit disruptions, stabilize the economy, and lay the groundwork for the resumption of long-term growth. Yet, the policy response involves difficult judgments and unpleasant tradeoffs amid significant uncertainty. Measures may have temporary side effects and—especially if reforms are not fully carried through—a country can remain exposed to significant post-crisis vulnerabilities.
It is striking how, over the last thirty years, crises in many countries have become recurrent. Recent research we have undertaken at the Fund shows that this is particularly true in Latin America. Since 1980, 22 Latin American countries have suffered either a financial crisis or financial distress, in the latter case narrowly averting a full-blown crisis. Of these 22, three countries have experienced four episodes each; three countries have experienced three episodes each; and nine countries have experienced two episodes each. For example, Argentina has suffered four crises, in 1980, 1989, 1995 and 2001. Ecuador suffered three crises, in 1982, 1996 and 1998, and narrowly averted one in 2002. Brazil and Bolivia each experienced two crises between 1985 and 1995, and pulled back from the brink in 2002 and 2003, respectively.
I feel that more systematic research on recurrent crises is urgent. In trying to advance some ideas on the issue, I would venture to say that—all too frequently—the compromises that are made with the intent of resolving current difficulties may actually sow the seeds for the next crisis.
Accordingly, I would like to focus my remarks today on four issues, which I think are critical for the international community to better understand our efforts to improve the policy response to financial crisis:
- First, the complexities involved in designing an appropriate policy framework;
- Second, the “ugly” tradeoffs policy makers face in formulating policy options;
- Third, the post-crisis vulnerabilities that might remain and the need for countries to persevere in their efforts to reform and to “crisis-proof’ their economies; and
- Last, the role of the Fund in this context.
First, consider how difficult it is to identify the appropriate policy framework. There is uncertainty regarding the scope and impact of a crisis. In the midst of a crisis, key macroeconomic variables tend to display unusually high volatility. The resilience of the economic system and the severity of the crisis are uncertain. As a matter of fact, once a crisis has erupted and the Fund’s mission starts its groundwork, it is not uncommon that preliminary assessments need to be revised as, in a crisis environment, hidden liabilities—both public and private—can pop up like rabbits out of a hat.
Balance sheet interlinkages across sectors of the economy can amplify weaknesses in individual sectors and propagate a crisis across sectors, to the balance of payments, and to the sovereign. Such interlinkages may complicate the policy response and magnify the costs of crisis resolution. There is also uncertainty regarding the effectiveness of policies, which depends critically on the perceived credibility of the corrective measures when the reputation of the authorities tends to be at its lowest level. And there is uncertainty regarding the political support for reforms. Policy makers face the additional challenge of quickly mobilizing public support for often unpopular measures.
Against this background of economic and political uncertainty, the policy response is often subject to “ugly” trade-offs. A prime example is the fiscal consolidation that may be required to reduce imbalances or debt burdens. This must be sufficient to strengthen confidence in the sustainability of public finances, but not so much as to undermine medium-term growth prospects.
In cases where a banking crisis is part of the problem—such as the recent crises in Argentina, Turkey and Uruguay—public support will likely be required to safeguard the functioning of the domestic financial system. But this support can exacerbate debt sustainability concerns and make the previously mentioned tradeoff even more difficult. Moreover, in extreme situations, administrative measures may be seen as unavoidable for quelling a banking crisis—although these risk eroding confidence in the banking system and triggering capital flight and financial disintermediation.
In cases where sovereign debt restructuring is needed, the benefits of alleviating the liquidity or solvency constraint must be weighed against the implications for future access to capital markets. In addition, policymakers may need to factor in the potential costs to the domestic financial system if bank portfolios are significantly exposed to government debt.
Next, consider how—even if a credible adjustment quickly restores confidence—a number of vulnerabilities can linger and perhaps even increase. Public finances may remain vulnerable to shocks. If public debt remains at high levels, gross financing requirements continue to be large, and thus vulnerable to shocks or spells of market drought. Banks may remain vulnerable to debt servicing difficulties of household and corporate sectors, or because of a large exposure to sovereign debt. And in cases of sovereign debt restructuring, a country may lose access to markets for a prolonged period of time.
Perhaps most importantly, there is always a danger of “reform fatigue.” As countries move out of the critical stage in the process of crisis resolution, it is not unusual to see some of them lose their drive towards reform. Several factors contribute to this: a) the erosion of political capital; b) an early positive response from investors that might lead to complacency; and c) the fact that many of the needed reforms do not induce immediately higher growth and wellbeing of the population. But here is precisely where the recurrent crises have their genesis. Once the most urgent measures have been implemented, the tendency is to put aside the important ones for later. The message is clear: it is critical that countries persevere with reforms to “crisis-proof’ their economies and avoid recurrence of financial distress.
Finally, let me say a few words about the role of the IMF in crisis resolution, and how we are working to improve it. A key role of the Fund is to work with members to achieve a durable exit from crisis. The Fund helps members to consider the relevant constraints and trade-offs and to design an appropriate adjustment program that addresses underlying macroeconomic problems, as well as anchors investors’ expectations about the formulation and implementation of economic policies. In helping to design this program, the Fund has to form a judgment about the appropriate balance between the availability and scale of IMF financing, the amount of domestic policy adjustment, and securing the support of other stakeholders (official and private creditors). And in forming this judgment, the Fund must also consider the implications a crisis country may have on the stability of the international financial system.
Based on previous experience, we are continually examining policies that could help reduce the frequency and severity of crises. We are focusing on several issues at present, including reinforcing the rigor of our debt sustainability analysis, especially through a more thorough analysis of contingent claims. We are working to raise awareness of balance-sheet vulnerabilities, to ensure that risks are properly assessed and effectively addressed. We have taken steps to improving clarity about IMF lending decisions, especially with regard to the situations when exceptional access to IMF financing may be appropriate. And we are working to improve the process for restructuring sovereign debt within the existing legal framework. This includes encouraging the use of collective action clauses (CACs) in new sovereign bond issues, as well as supporting private sector efforts to formulate a voluntary Code of Conduct.
Strong banking systems are a foundation for financial stability. Therefore, we have been working also with the Basel Committee and its chairman, Governor Caruana, in encouraging emerging market countries to move towards the adoption of the new set of standards embodied in the Basel II Accord, ensuring that this transition occurs at their own pace and based on their own priorities.
Ladies and Gentlemen, notwithstanding all these efforts, there is no doubt that substantial challenges are still in front of us. Therefore, in closing, I would like to commend the organizers of this conference for bringing together distinguished economists and policymakers that through their interventions will shed some light on the critical issues involved in building a more stable international financial system. Yet our main challenge will be to put all of these ideas together, into a coherent strategy for crisis prevention and resolution that is both effective and durable. If we can do this, we may also be able to abate the recurrence of crisis.
The International Financial Architecture - Where Do We Stand?
Remarks by Jean-Claude Trichet, President, European Central Bank, at the Bank of Spain and IMF International Conference on Dollars, Debt and Deficits - 60 Years after Bretton Woods
June 14, 2004
It is a great pleasure to be here in Madrid at the invitation of the Banco de España and the International Monetary Fund. The 60th anniversary of the Bretton Woods institutions is indeed an important opportunity to take stock of key events, developments and issues that have shaped and are shaping the international financial system. Let me thank the organisers, and especially our host Jaime Caruana, for setting up a very interesting programme for this conference that encompasses all these key topics. Tonight, I would like to offer some thoughts on the question “the international financial architecture – where do we stand?” In my remarks, I will first have a short look back at the changes to the international architecture over time, before concentrating on reform efforts that have been undertaken in four areas, namely the institutional setup, transparency and best practices, regulation of financial markets and crisis prevention and resolution.
Let me briefly look at the changes to the international financial architecture over time. The key aim of today’s policy makers has not changed compared to those at the Bretton Woods times - it has been, and still is, global prosperity and stability - but the environment in which we are acting has changed profoundly. The founders of the IMF and the World Bank wanted to create institutions that prevent countries from falling back into autarky and protectionism and that help them to raise growth and increase stability in a world of fixed exchange rates with still a large degree of capital controls. Today we are striving for stability of the international financial system in a world of free capital flows with a growing importance of private flows and increasing trade and financial integration. Among the major factors that we have to take into account, I would like to mention in particular:
- The financial globalisation phenomenon: capital market liberalisation, both domestically and internationally, technological advances and buoyant financial innovations have contributed to set up a totally unknown degree of financial globalisation - with great benefits, but also new risks.
- The policy responsibility which still lies mainly with sovereign states; thus, the challenge is to promote global financial stability very largely through national actions enlightened and co-ordinated through a larger degree of intimate international co-operation.
- A very large consensus on giving the private sector and markets a central role on the one hand, and relying upon sound public institutions to provide market participants with the appropriate environment on the other hand. This shift from direct public involvement to private activities is particularly striking when looking at financial flows to emerging markets: in the 1980s, official flows were dominant, reaching on average over 60% of total flows to emerging markets. By contrast, the 1990s saw a dramatic increase in private flows, which on average accounted for around 85% (in the period from 1990 until 2003). Equally striking is the shift from bank loans to negotiable securities as the major financing tool for the developing countries.
- The integration of the European Union, reinforced with the introduction of the euro, has increased the economic, monetary and financial stability of a region that constitutes today the world’s largest trading partner and the second largest economy. The EU has also been crucial in anchoring the transition process in central and Eastern Europe, and in fostering stability and prosperity in this region.
The dynamics of today’s world call for continued adjustment at a global level. New challenges have been added to existing ones, such as poverty reduction. New actors gained prominence on the international scene, with developing and emerging markets becoming progressively full participants in the globalised economy. The financial crises of the 1980s and the 1990s, characterised by large and sudden private financial flow reversals, marked by a very powerful contagion phenomenon and demonstrating some of the potential and actual vulnerabilities of the newly globalised financial system, led to an ambitious reform agenda to strengthen the international financial architecture.
Let me focus on the lessons from the crises in the 1990s and the ensuing work on the international financial architecture.
On the basis of the experience with the Mexican crisis in 1994/95, the G7 summit in Halifax in June 1995 initiated work on improved crisis prevention and management. It called for improved transparency, both at the level of individual countries and at the IMF, and for strengthened IMF surveillance. The Halifax summit also pointed to the importance of effective financial regulation, market-reinforced prudential supervision and enhanced international co-operation among regulators and supervisors. As for crisis management, concrete proposals were presented in the Rey report to G10 Ministers and Governors in May 1996.
Work was stepped up in the aftermath of the Asian crises, which revealed further vulnerabilities in national and international financial systems. But most importantly, the crises in the later 1990s showed that the systemic changes in the world’s financial markets required systematic changes in the policy framework that underlies the international financial system. Almost a decade later, we can say that many of these proposals have been implemented. Let me now focus on four different areas, which I consider most important:
The first area concerns the international institutional set-up, which, in my view, has been strengthened significantly since the 1990s. The existing international financial institutions, in particular the IMF, the World Bank and the BIS maintained their central role in the system But they were subject to several changes to sharpen their respective focus, to reinforce their policy advice and financial support, to enhance their transparency and accountability and to strengthen their governance. The Bretton Woods institutions, and particularly the IMF, underwent profound changes to adapt to the new environment. In addition, new fora have been created in response to the widening of the number of actors in the global economy and the growing importance of international financial markets. The creation of the G20 in 1999 constituted in my view a decisive and highly welcomed step to reflect adequately the newly globalised economy. The G20 has turned into the international forum for appropriate dialogue and consensus building between all economies that have a systemic influence, whether industrialised, emerging, or in transition. Equally important is the Financial Stability Forum, which is the first informal grouping to fully recognise the existence of a globally integrated economic and financial system It is also the first forum to set the goal of systemic optimisation of each of the subcomponents of the system, whether it is banking surveillance, insurance surveillance, securities market control, accounting rules, good practices of public and private sectors, functioning of the major market places, governance of the IFIs etc. At the regional level, the European Union has established a whole universe of arrangements for co-operation that is constantly being adjusted to its changing needs and European institutions are becoming increasingly involved at the international scene, for instance with the EU-US regulatory dialogue.
Overall, improving the governance of the international institutions and optimising the work of the informal groupings will always remain a moving target given that these entities permanently will have to adapt to a changing environment. However, with the changes introduced in the recent years, the foundations of the international financial system have been strengthened considerably.
The second area I would like to highlight regards the work to enhance transparency and promote best practices, where significant progress has been achieved in a number of fields. Indeed, a wide-spread consensus has developed, which considers reliable and timely information on economic and financial data as a precondition for well-functioning markets, since it facilitates better risk assessment and management and hence strengthened market discipline. The IMF’s special standard for dissemination of economic and financial data has become a widely recognised benchmark to which a large and increasing number of countries have subscribed. There is now a presumption that IMF papers on Article IV consultations and on Fund programmes are published. International codes of good practices have been agreed upon, such as the ones on transparency in fiscal policy and on transparency in monetary and financial polices. Moreover, countries’ compliance with the 12 most important standards and codes are regularly examined by the IMF and the World Bank in socalled ROSCs (Reports on the Observance of Standards and Codes), many of which are made publicly available and have a positive impact on the market’s assessments of the countries concerned.1 I consider that the progress made in the field of transparency after the Asian Crisis is one of the main explanations for the absence of contagion in the emerging world when the Argentine crisis erupted.
Transparency in the private sector is also crucial for well-functioning international financial markets. Reliable and timely company information are one key element to transparency, which is provided mainly through financial statements. Recent corporate scandals have again brought to our minds the crucial role that accounting standards play in this respect. In this context, I attach great importance to the reform of the International Accounting Standards (IAS) and the key role of these standards in advancing the European single market. The IAS, which will apply to all listed companies in the EU, are expected to have a major impact on the European banking system The banking sector will particularly be affected through the proposed valuation rules for financial instruments and through the rules on disclosure.
The ECB has a strong interest in this debate mainly from its focus on contributing to the maintenance of financial stability. Thus, the primary objective of this reform has our full support as it aims to minimise the gap between the reported information and the true risk profile of a company. I am also fully aware of the complexities stemming from the interrelation of accounting standards with other reporting schemes for supervisory and statistical purposes. However, some proposals have given rise to concerns also within the ECB. In particular, those proposals relating to an extensive use of fair values raised concerns about the possible adverse implications on the volatility of bank income and, eventually, on bank behaviour and on financial stability. As a consequence, the ECB contributed to this debate, highlighting the concerns and showing their relevance. The more recent proposals from the IASB moved into the direction of limiting the use of fair values for those items that can be reliably measured. The revised proposals should help to avoid undesirable consequences such as an artificial increase in income volatility. At the current juncture, the ECB is carrying out an exercise to check the likely impact of the new standard.
While these issues apply to all financial markets, the EU faces a particular challenge relating to the advancement of the single market. The introduction of harmonised EU rules regarding the setting-up of financial statements are considered to be a crucial step towards the further integration of the financial markets in the euro area and the European Union. Indeed, improved comparability of disclosed information would facilitate cross-border investment and further market integration. Thus, in 2002 the European Parliament and Council adopted a Regulation requiring listed companies to prepare consolidated financial statements in accordance with IAS from 1st January 2005. A specific endorsement process is in place to ensure legal certainty and consistency with EU public policy concerns. This process already allowed to endorse all IAS with the exception of the two standards concerning recognition, measurement and disclosure of financial instruments. Recently, in order to deal with the remaining controversial issues, the Commission took the initiative to establish a high-level dialogue between all the constituencies interested in high quality accounting principles. I remain confident about the positive impact of prudently implemented International Accounting Standards on the stability and efficiency of financial markets in the EU.
The third area relates to the strengthening of financial regulation in industrialised countries. Here, let me recall that recent crises exposed weaknesses in the risk management practices on the part of creditors and investors in industrial countries, pointing to the importance of financial market regulation and supervision.
We all are aware of the importance of effective financial regulation and supervision to maintain financial stability and protect consumers, also in light of the increased complexity of financial services and products. Let me say one word on one important aspect of financial regulation, which is the reform of the Basel Capital Accord, coined Basel II. I am convinced that our host, Mr. Caruana, who is the chairman of the Basel Committee on Banking Supervision, could off hand fill the evening by elaborating over the main features of this reform. From what I gather, your efforts are bearing fruits and we may expect a final text to be hopefully endorsed by the G10 Governors and the Heads of banking supervisory authorities in the forthcoming weeks.
The Basel II reform is of key importance. New and bold developments in the banking industry are the ultimate reason for engaging in this reform.
The ECB has expressed on various occasions its supportive stance to the new framework. The ECB was also among the first to point out the possible macro-financial implications of any banking prudential scheme, highlighting the potential procyclical effects that might be induced by any framework relying on a comprehensive real time risk analysis. These concerns have been taken into account in the final version of the new framework which aims at being neutral over the cycle. Looking ahead, we have to recognise that we stand at the beginning of the road. The success of this reform will crucially hinge on a sound implementation of the new framework requiring strong coordinating efforts among the supervisory authorities on a global basis. With regard to the EU context, the new institutional setting based on the Lamfalussy framework comprising a two-tier structure of regulatory and supervisory committees is expected to play an important role in ensuring a more uniform and flexible EU regulation and consistent implementation resulting from convergence in supervisory practices.
As the fourth and last area, I would like to mention crisis prevention and management. Of course, the various efforts I mentioned so far should be conducive to prevent crises from happening. However, crisis prevention primarily rests with every single country with strengthened macroeconomic policies and financial systems. In that context, the experience of the past decade has highlighted the crucial importance of well-functioning domestic rules, regulations and institutions namely the legal framework, the regulatory system, the enforcement mechanisms, and authorities that shape and permit the optimal functioning of a market economy with its financial markets. This includes, in particular, central bank independence, rules for monetary policy and for fiscal policies, appropriate supervisory frameworks and authorities. There is strong evidence linking well-functioning institutions and good governance to positive economic and social outcomes. Institutional factors appear to be as important as productive factor endowments or any other explanations in determining cross-country differences in the overall level of development.
I am confident that these lessons feed into improving domestic policy-making in emerging market economies, making them more resilient to withstand shocks. The continued efforts to strengthen IMF surveillance play also a crucial role in that respect.
It is clear that crisis prevention must remain the key area of all our efforts. Crises are costly for the countries concerned and also for the international system. Given the increasing economic and financial importance of emerging markets, major events in these countries are bound to have spill-over effects to the rest of the world. Let me underpin this argument with some figures: In the last four years, major emerging markets contributed to about half of global real GDP growth (in PPP terms), accounted for roughly 30% of world exports and received about 20% of global FDI.
Turning to crisis management, important lessons have been learnt. There has been a growing recognition that more predictability is required on the side of the official sector in order to set the right incentives for all the actors involved. Moral hazard concerns and the limited availability of official funds also led to increasing discussions about the appropriate involvement of the private sector in crisis management. Of course, every single crisis is different and hence there is in each case the need to find the appropriate balance in the triangle of domestic adjustment, private sector involvement and official support. Therefore, crisis management in practice still has to struggle with the inherent tension between rules and clarity on the one hand and discretion and flexibility on the other.
However, considerable progress has been achieved. First, specific criteria and procedures have been set up last year to make exceptional access to Fund resources subject to rules and hence more predictable. We in Europe have been very much in favour of setting such clear rules and clear limits to Fund financing in view of the very large financing packages provided to countries in the 1990s. The IMF’s debt sustainability analysis will play an important role in that context, since clear limits to official financing must be respected especially when a country faces an unsustainable debt burden and hence requires a debt restructuring. All IMF shareholders now need to stick by these rules, not least in order to provide the right signals to the markets and to avoid the impression that the official sector suffers from time inconsistency between the approval of policy principles and their actual implementation.
Second, following Mexico’s bond issue with Collective Action Clauses (CACs) in February 2003, several emerging markets included CACs in bonds issued under New York law. More than 70% of new bond issues since early 2004 include CACs. As you probably know, no discernible impact on borrowing costs could be detected. In order to help making CACs a standard feature in sovereign bond contracts, the EU Member States committed themselves to include CACs when issuing new bonds under foreign jurisdiction. All this progress is very remarkable, especially when comparing it to the rather sceptical stance many countries and many private sector representatives have taken in the past vis-à-vis the recommendations in the Rey report after the Mexican crises. Of course, so far these clauses have not been tested in practice and it will take some time until CACs are included in the entire stock of debt.
Finally, work is proceeding on a so-called Code of Good Conduct, which I suggested myself at the IMF Annual Meetings in September 2002. Such a Code would define best practices and guidelines for the behaviour of debtor countries and creditors regarding information-sharing, dialogue and close co-operation in times of financial distress. While the IMF and the G7 encouraged further work and the G20 is closely following the process, at present the official sector confines itself to a catalysing role and leaves the floor to the true stakeholders in the process, i.e. emerging market issuers and private sector representatives. I understand that currently intensive discussions are taking place on the main elements of such a Code. I would like to encourage all parties to be as active and constructive as possible in working out what could be a significant new tool to prevent and help solving potential crises.
We have the unique chance of living in a world which is full of opportunities, very inspiring and very complex, very rewarding and very demanding, full of chances and of risks. We have all been the witness of two incredible transformations of the global economy over the last twenty five years. The technological surge which has permitted to compute and to transfer information at practically no cost. The globalisation process which aims at connecting all economies and finances of the world within the same market-economy based framework. So that goods, services, capital, technologies, concepts, ideas are moving very rapidly or even instantaneously all over the globe, expanding considerably, in quality and in quantity, the domain of the Ricardian comparative advantage. The significant surge of labour productivity in a number of industrialised economies, the taking off of India, China and a very large number of emerging countries, the rapid race of global growth. These are great successes of today’s economic world of which global finance, mirror-image of a global economy, is both the emblem and the very powerful tool. But there is no economic success without risks. We have been living permanently in a risky environment over the last twenty-five years. Amongst many risks, we might mention: the debt crisis during the 1980s, starting with Poland and Mexico and spreading to Latin America, Africa, the Middle East and the Soviet Union; the stock exchange fall in 1987; the Mexican crisis in 1994; the bond market crash in 1994; the Asian crisis starting in 1997; the LTCM and Russian crises in 1998; the recent stock exchange fall and the collapse of the technology bubble in 2000. We have surmounted all these crisis episodes. We have learned a lot and we have improved a lot in these occasions. One of my friends used to say: “Good management comes out from experience and experience comes out from bad management!” I think we are pretty experienced now and I take it that thanks to the lessons drawn we have now achieved a level of crisis prevention which is much better. But we should never forget that the risks are still there because they are intimately associated with the structural transformation of the global economy. This is not, in any respect, a time for complacency.
If I had to sum up what should be our today’s mottos, I would make the following five recommendations:
- Let us not forget the crucial role of the IFIs, in particular the Bretton Woods institutions, in the management of the present global economy. The constant improvement of their management and instruments is key;
- Let us tirelessly improve transparency in all fields: it is the best recipe for avoiding both misallocation of capital and global crisis contagion;
- Let us continuously improve the flexibility of our economies through bold structural reforms. Not only because it improves efficiency but also, all the more, because it improves resilience in a world where shocks are to be expected;
- Let us reinforce our methodology to ensure that we do not amplify “pro-cyclical” phenomena: the best envisaged at a local or sectoral level can be the enemy of the good at a global systemic level. In this respect such informal groupings like the G20 and the Financial Stability Forum are of the essence;
- Let us join efforts to improve our scientific knowledge of the new world economy. Still today, academics and practitioners are observers and actors within the environment of largely uncharted territories. The more profoundly we understand the functioning of today’s global economy, the more efficient we will be to weather stocks, to prevent crisis, and to pave the way for continental and global job creation, steady growth and overall stability.