Laurence H Meyer: Financial Stability in Emerging Markets - What Have We
Accomplished and What Remains To Be Done?
Remarks by Mr Laurence H Meyer, Member of the Board of Governors of the US Federal Reserve
System, at the Center for Strategic and International Studies, Washington, 18 December 2001.
* * *
Economic crises in emerging-market economies were a prominent feature of the economic landscape
during the second half of the 1990s. Though such crises were by no means a new phenomenon, what
brought special attention to the recent episodes was the perception of a heightened possibility of
contagion--the spread outward of pressures from one crisis country to other countries. The risk of such
contagion became evident when the collapse of Thailand's currency triggered a cascade of crises in
other Asian emerging markets. Pressures could also spread through world financial markets to
industrial economies, as happened with the Russian financial crisis.
In the wake of the Asian crises in particular, initiatives were launched on several fronts to improve
financial stability in emerging-market economies and thus to reduce the frequency and intensity of
future crises. These initiatives have ranged widely, from efforts to improve policymaking in
emergingmarket economies in areas such as choice of exchange rate regime and debt management to
development of international standards and codes of best practices and to reforms of international
financial institutions. Today, I venture an assessment of how much progress has been made and how
much remains to be done. I believe that there have been improvements in our understanding of the
causes of crises, in economic policymaking in emerging-market economies, and in international
institutional arrangements. The key to preventing future financial crises is for emerging-market
economies themselves to institute sound domestic economic policies and to build robust domestic
financial institutions. No improvements in international financial architecture can make up for
deficiencies in these crucial areas.
Reducing Contagion and Promoting Financial Stability
Before I evaluate prescriptions for reducing the likelihood of emerging-market financial crises, I need
to examine the causes of such crises. In general, financial crises result from adverse shocks to an
already vulnerable economy. External shocks that a robust economy would shrug off can have a
disproportionate impact on an economy beset by speculative excesses in asset markets, poor risk
management, and inadequate regulation and supervision of the banking system.
In broad terms, this describes the Asian emerging-market economies in the run-up to their crises in the
late 1990s. Countries in the region did experience external shocks, including a slump in the
semiconductor market and an appreciation of the dollar relative to the yen, that undermined their
competitiveness. However, these shocks alone were not sufficient to account for the dimensions of the
ensuing crises. The problem was that the shocks hit economies suffering from speculative excesses in
their financial and real estate markets. Serious deficiencies in corporate governance and prudential
oversight resulted in inadequate restraint on firms' indulgence in risk. Financial sectors were
weakened by political interference in lending decisions and the moral hazard associated with
wideranging, albeit often implicit, government credit guarantees. As a result, banks had insufficient
incentives to manage their credit risks, and firms had inadequate incentives to limit their leverage and
make sound investments. In particular, the corporate sector was enormously leveraged, and
longerterm domestic investment projects were financed with shorter-term foreign-currency-denominated
borrowing. Pegged exchange rate regimes in the presence of volatile international capital flows
created additional vulnerabilities. Financial sector weaknesses, rigid exchange rate regimes, and
volatile capital flows combined to yield a highly combustible mixture that, with the spark of adverse
external shocks, ignited currency and debt crises, including the collapse of banking systems
throughout the region
The Asian crisis experience highlights the crucial importance of robust institutions and sound policies
in mitigating the risks emanating from external financial shocks. One implication of this view is the
importance of policy "sequencing" in emerging-market economies. Sequencing involves constraining
the pace of increased participation in global financial markets to the pace at which a sound domestic
economic infrastructure can be put in place. In particular, capital account liberalization in emerging-
market economies needs to be preceded by significant progress in strengthening domestic financial
systems. If liberalization proceeds too rapidly, the economy becomes vulnerable to risks associated
with volatile capital flows. In the years leading to the Asian financial crises, the region moved toward
capital account liberalization while domestic financial institutions and regulations were still
underdeveloped. This mismatch encouraged excessive foreign borrowing, especially at short-term
maturities, that greatly exacerbated the impact of the crises.
Of course, some policymakers could use sequencing as a pretext to put off capital account
liberalization indefinitely. With this concern in mind, some have argued that we really need to
encourage rapid liberalization, independent of the state of financial sector institutions, in the hope that
financial liberalization would pressure the authorities to improve supervision and regulation more
quickly. I believe that the Asian crisis provides a strong argument against this approach. Before
proceeding with capital account liberalization, a country needs to carefully consider deficiencies in
domestic financial institutions, corporate governance, and bank regulation and supervision.
Emergingmarket economies in which such financial market infrastructure is still in an early stage of development
should consider the use of prudential regulations that discourage capital inflows, especially short-term
capital flows, along the lines of the approach formerly in place in Chile. Such regulation of capital flows
may be appropriate in the period before robust domestic institutions and sound policies are fully in
place and tested by experience.
The Process
The Asian financial crises generated several initiatives aimed at preventing or better managing future
crises. The academic and policy communities have sought a better understanding of the causes and
transmission mechanisms of crises. There have also been initiatives to reform what has come to be
called the international financial architecture. Issues related to the prevention and management of
emerging market financial crises have entered the agenda--and sometimes dominated the
discussions--of the G-7 in recent years. In addition, some groups have been formed specifically to
study such issues. The G-20, which includes finance ministers and central bank governors from major
emerging-market countries in addition to the G-7, was launched in September 1999 to facilitate
dialogue between systemically important countries and to promote international stability. The G-20 has
recently focused on reform of the international financial architecture and the implications of
globalization.
I have participated in two of the new groups established in response to the Asian financial crisis: the
Manila Framework Group and the Financial Stability Forum. I represented the Federal Reserve at the
first Manila Framework meeting and in the Financial Stability Forum for the last few years. My focus in
these groups has reflected my specialties at the Board, including Asia-Pacific developments and bank
supervision and regulation.
The Manila Framework Group was founded in November 1997, in the throes of the Asian crisis, with
the aim of restoring financial stability in the region. It consists of finance ministry and central bank
officials from fourteen Pacific countries, including the United States. The group has met twice a year
and has undertaken a number of studies and launched cooperative ventures among its members.
The Financial Stability Forum was established by the G-7 in April 1999, after the Asian and Russian
financial crises, to provide a means for cooperation in the supervision of financial markets among
national governments, international financial authorities, regulatory groups, and other experts. The
forum's membership includes central bank and treasury representatives and a financial services
supervisor from each of the G-7 countries; a single representative of a few more economies; and
representatives of several international financial institutions and of global standard setters for banking,
securities, and insurance. The forum is supported by working groups, committees, and task forces,
which often include the participation of several emerging-market countries. The forum's mandate is to
identify vulnerabilities affecting the international financial system and to improve coordination and
information exchange among the various authorities responsible for financial stability. Its working
parties have addressed issues such as off-shore financial centers, highly leveraged institutions, and
short-term capital flows.
The international official community has also taken up initiatives to reform the international financial
institutions, inspired in part by proposals put forth in 1999 by Lawrence Summers, then Treasury
Secretary. As a result of this process, the International Monetary Fund (IMF) and the multilateral
development banks have instituted many changes, which I will discuss in more detail later, and reform
initiatives continue.
What We Have Accomplished
Recent work, both under the auspices of the groups I just enumerated as well as elsewhere, has
resulted in substantial achievements. We have a better understanding of the policies and institutional
frameworks best suited to creating financial market stability in emerging-market economies, and
changes in the international institutional environment have facilitated the adoption of such policies. I
want to discuss five of the most important changes--choice of exchange rate regime, debt
management policies, promulgation of standards and codes, reform of the international financial
institutions, and private-sector involvement in debt restructurings.
Exchange Rate Regimes
The financial crises that enveloped Mexico, Russia, and several Asian developing countries in the
1990s reinforced what already appeared to be a growing consensus against pegged exchange rates.
The experiences of these countries showed that pegged exchange rate regimes greatly limited the
ability of real exchange rates to adjust in reaction to external shocks and restricted monetary
authorities' ability to correct excessive growth of credit or to act as lender of last resort. Fixed rates
also tended to encourage excessive borrowing of foreign currency, by reducing concerns about
exchange rate risk, and contributed to particularly abrupt and disruptive reversals of investor
confidence once exchange rate pegs were broken.
Some countries, particularly those in which monetary policy has had low credibility, have felt that the
adoption of a fixed exchange rate was necessary to reduce inflationary expectations. In particular,
countries with histories of high inflation and poor macroeconomic management may have felt the need
for fixed exchange rates, at least for a transitional period, until they developed a better track record for
policy performance. In such cases, a key question is how long the rigid exchange rate regimes must
stay in place before inflationary expectations can be reduced.
The experience of the 1990s suggests that, in the context of rapid international capital mobility,
sustaining a fixed exchange rate in the face of domestic policy imbalances or international financial
market shocks is very difficult, and a forced abandonment of a pegged rate under pressure has proved
quite disruptive. To provide greater stability to fixed-rate regimes, some countries have adopted
currency board systems or moved to full-blown dollarization. However, such moves are by no means
panaceas, as evidenced by Argentina's current difficulties. Considerably more countries have moved
in the opposite direction--toward more freely floating exchange rates--often following experiences in
which their pegged exchange rates proved not to be viable.
I believe that, as a general rule, flexible exchange rate regimes are the best choice for
emergingmarket economies. A fixed-rate regime is appropriate only in the relatively rare instances in which it
can be fully credible. The fact that many policymakers in emerging-market economies seem to have
adopted a similar viewpoint in recent years provides some grounds for optimism that, in the future,
emerging-market economies may experience fewer and less severe financial crises.
Debt Management
In recent years, a broad consensus has emerged within the international official community that
prudent debt and liquidity management is a key element of crisis prevention. Emerging-market
economies that experienced financial crises in the late 1990s generally had significant mismatches in
the composition and maturity of their liabilities and assets that left them vulnerable to external shocks.
In particular, almost all the crisis countries had high ratios of short-term external debt to foreign
reserves. There was too much emphasis on borrowing strategies that aimed simply at minimizing
short-term funding costs and that, in the process, created significant rollover risks. Authorities also
failed to adequately monitor national balance sheets on a consolidated basis, while taking into account
off-balance-sheet obligations, implicit government guarantees, and various other contingent liabilities
that might arise if the private sector were unable to honor its obligations.
One general principle to draw from this experience is that emerging-market countries should avoid
issuing large quantities of short-term debt because ongoing exposure to rollover risk intensifies
vulnerability to changes in market conditions. Some initial fiscal cost may be associated with
lengthening debt maturities because long-term interest rates generally are higher than short-term
rates. However, to the extent that lengthening the maturity of a country's debt improves its fiscal
viability and reduces the likelihood of having to borrow at the high rates charged during a crisis, any
increase in debt-service costs should be seen as a prudent insurance premium. In addition, the
development of domestic government securities markets, in which debt denominated in local currency
can be issued, can help reduce the vulnerability to shifts in global capital flows.
The international financial institutions have launched several initiatives to help emerging-market
countries improve their debt- and risk-management policies. Last year, the IMF and World Bank staffs,
responding to discussions initiated by the Financial Stability Forum, completed a document entitled
"Guidelines for Public Debt Management" that was based on some of the principles just discussed.
These guidelines will be used to inform the IMF's technical assistance and surveillance efforts. The
IMF is also conducting research examining various indicators that may serve as guideposts for debt
and may help in managing reserves in emerging-market economies.
Standards and Codes
Among the initiatives that arose from the emerging-market crises was the international official
community's effort to articulate "standards and codes" to encourage improved practices in the
economic and financial policies of emerging-market countries. Some noteworthy progress has been
made in this area. Standards and codes have been developed that cover a wide array of areas,
including data quality and dissemination, transparency in monetary and fiscal policy, and best
practices in banking supervision, payment systems, and accounting standards. The Financial Stability
Forum has focused on ways to provide incentives for greater compliance with the standards and
codes. The IMF is leading the implementation of this effort, but other international bodies--including
the World Bank, the Basel Committee, and the Organization of Economic Cooperation and
Development--are also taking part. Examples of actions so far include the Financial Sector
Assessment Program, under which IMF and Bank staff assess the strengths and vulnerabilities of
member countries' financial sectors, and the IMF preparation of reports on the observance of
standards and codes, which address a country's progress on meeting standards in a broad range of
areas.
While promising, these initiatives have not been without difficulties. Implementation and compliance in
the emerging-markets countries is uneven, and much remains to be done. Market participants are
beginning to pay more attention to compliance with standards and codes, but scope for significant
progress in this area remains. For example, compliance does not appear to be important in setting
credit ratings or lending terms. More fundamentally, some emerging-market countries have
complained of a lack of sensitivity to their particular circumstance, and have called for a more realistic
view of the feasible pace of reform and clearer priorities. For emerging-market economies, it makes
sense for standards and codes to focus on minimum standards because the appropriate standards will
vary across countries depending on the resources and experience of officials, the structures of
financial systems, and the cultural values and norms. Because a country may have unique
circumstances, not all international standards are appropriate for each emerging-market economy. In
the Basel II process, for example, standards appropriate for large, internationally active banks in the
developed industrial economies may be inappropriate for emerging-market economies.
Reform of International Financial Institutions
Another focus of reform efforts in recent years has been the international financial institutions.
Changes have been made, and more are planned. The IMF's lending facilities have been modified,
including the introduction of an "expectation of early repurchase," which will tend to reduce the
maturity of IMF lending, and an escalation of loan charges once a country's outstanding obligations to
the IMF exceed certain thresholds. These measures are intended to encourage countries' return to
capital markets as quickly as possible and to discourage excessive dependence on IMF financing.
The IMF also has recently moved to make the pricing of its Contingent Credit Lines, or CCL, more
attractive to potential borrowers. The CCL was established in 1999 to provide liquidity to prequalified
countries with track records of sound policies. However, this facility has never been used. Countries
have expressed concerns that the benefits of being prequalified are more than offset by the potential
costs of being disqualified if their policies subsequently are deemed to have weakened. Countries
have also voiced concerns that simply applying for the CCL may be interpreted by the markets as a
signal of vulnerability.
As mentioned previously, the IMF has also moved to improve its ability to assess the economic and
financial vulnerabilities of its members, including efforts to identify national balance sheet and liquidity
risks, as part of a broader initiative to strengthen the IMF's surveillance efforts. Measures to
discourage misreporting have been strengthened, and efforts have been made to make the IMF's
operations more transparent, including the publication of policy documents.
The role of conditionality in IMF programs has been a subject of ongoing debate. Critics have argued
that these programs, particularly those constructed during the Asian crises, have carried too many
detailed conditions and have focused disproportionately on structural objectives rather than on the
macroeconomic issues that are the IMF's core mandate. It has been argued that this represents
micromanagement and reduces the scope for country ownership of adjustment programs. In response
to this critique, the IMF has said that it is moving to streamline and focus conditionality, particularly
with respect to structural measures, and to provide greater clarity as to why conditions in certain areas
are included in or excluded from programs. Though efforts to provide greater focus to conditionality
are welcome, they should not come at the expense of the underlying rigor of Fund programs or the
protection of its resources that conditionality provides.
There have also been initiatives to reform the multilateral development banks. It has been suggested
that there should be increasing selectivity in projects, a reform in pricing policies involving more
differentiation across lending activities and borrowers, and improved methods of monitoring the
compliance of borrowers. In addition, there have been calls for the IMF and the World Bank to show
greater sensitivity to the needs of the world's poorest countries. The process of translating these
general principles into concrete policies has somewhat progressed, but it appears still to be in its early
stages.
Private-Sector Involvement
An important and evolving aspect of dealing with emerging-market financial crises is what has come to
be referred to as private-sector involvement. The central issue here is the role of private-sector
creditors during default or restructuring of an emerging-market economy's debt. Unlike the bankruptcy
of a firm in a domestic market, for which procedures are generally codified and settled, the default of a
sovereign nation currently involves no binding legal jurisdiction or enforcement mechanism. The goal
of private-sector involvement is to ensure that, in a crisis, private-sector creditors, particularly
bondholders with instruments denominated in or linked to a foreign currency, participate in efforts to
resolve the problem. Such participation can take various forms--debt exchanges, rollovers,
restructurings, provision of new money, or outright losses.
The extent to which the private sector has helped resolve emerging-market crises has evolved over
time. During the debt crises of the 1980s, official support generally was focused on financing current
account shortfalls and easing the macroeconomic adjustment process. Bank creditors restructured old
loans, extended new loans, and eventually--under the Brady plan--exchanged their loans for bonds
with diminished value. During the 1990s, however, bonds became much more important as sources of
credit for many countries. This greater importance raised new issues for debt restructuring, given the
more atomistic and dispersed nature of bondholders as a group. The emergence of very large
international support packages--for Mexico in 1995, several Asian countries and Brazil in 1997 and
1998, and Turkey and Argentina more recently--may be seen in part as a response to the perceived
difficulties of engaging private creditors, particularly bondholders, in the resolution of emerging-market
debt problems. This point, however, should not be overstated. Many private investors--most notably
those who invested in equities--have taken substantial losses during recent crises.
The provision of large financial-assistance packages has been criticized because of a focus on only
two possible outcomes for emerging-market economies facing financial difficulties--either default or no
default, with the international official community viewed as often endeavoring to avoid default at all
costs. Developing procedures aimed at facilitating intermediate solutions--namely, some form of debt
restructuring with private-sector involvement--might, in this view, help avoid disruptive, corner solution
outcomes. Moreover, large support programs have been criticized for exacerbating so-called moral
hazard by encouraging overborrowing and overlending through leading investors to believe that the
official community will bail them out should debt repayment problems arise.
A key argument for private-sector involvement is that markets will price risk properly and allocate
resources efficiently only if investors are forced to bear the costs of their bad decisions. The hope is
that, if the broad principles for achieving private-sector involvement are known in advance, they might
reduce investors' uncertainty about the rules of the game and help to ensure that workouts proceed
smoothly and predictably. The principles could facilitate orderly resolution of financial crises and might
also help prevent crises by reducing uncertainty as to how investors would be dealt with during times
of crisis.
In recent years, a tremendous amount of discussion has been devoted to considering means by which
private investors could be involved during financial crises on an orderly, systematic, and predictable
basis. Yet these efforts still have a long way to go. Some members of the official community find it
difficult to accept the notion of sanctioning arrears or default. Also, some have concerns that strict
limitations on official IMF support could constrain the official sector when such support was genuinely
needed to avert international contagion.
Agreement on abstract principles of private-sector involvement remain elusive, but on the practical
level, instances of private-sector involvement are accumulating, laying down a foundation of practices
and precedents that should serve to make future restructurings more orderly and predictable. In recent
years, international bond restructurings have been conducted by Pakistan, Ukraine, and Ecuador as a
means of either dealing with an existing default or avoiding an impending default. In addition, the
IMFled financial assistance to both Turkey and Argentina has included various forms of private-sector
involvement. The authorities in Argentina are currently exchanging government debt on terms that
involve significant concessions from the private sector.
IMF First Deputy Managing Director Anne Krueger has recently weighed in on the issue of
international bankruptcy arrangements. She proposed that, in the event of an imminent financial crisis
by an IMF borrower, there should be, among other policies, an IMF-sanctioned temporary standstill on
debt-service payments and negotiated restructurings under IMF auspices of debts to private-sector
creditors. Though better international bankruptcy arrangements have certainly been a longstanding
need--as noted by Chairman Greenspan as far back as 1995, immediately after the Mexican crisis--an
initial reading of Krueger's proposal suggests that it would face very significant practical problems. The
major problem with the Krueger proposal, as with any scheme to establish international bankruptcy
arrangements, stems from the fundamental fact of the political sovereignty of nations. Debtor and
creditor countries alike would have to cede significant sovereignty to the IMF under Krueger's proposal
and would almost certainly prove reluctant to do so. Krueger's proposal merits further study, but some
of the more evolutionary, piecemeal changes in international debt-restructuring arrangements, which I
discussed under the general rubric of private-sector involvement, probably represent a more realistic
hope for near-term improvement in international bankruptcy arrangements.
What Is Left To Be Done?
I have outlined some of the main efforts to prevent or mitigate financial crises in emerging-market
economies. Now the question arises--What are the main tasks that remain to be accomplished? Many
of the initiatives that I have discussed, such as formulation of standards and codes, reform of the
international financial institutions, and development of procedures for private-sector involvement in
debt restructurings, are processes that are already well under way and that have a momentum of their
own. These areas do not so much need new initiatives as they do the extending, improving, and
implementing of existing initiatives.
For the future, the main objective should be to improve economic policymaking and institutions in the
emerging-market economies. All economies are subject to periodic external financial shocks. But
these shocks are unlikely to turn into financial crises if the country experiencing the shock has a sound
macroeconomic environment and robust, well- regulated financial institutions. It is hard to think of an
emerging-market economy experiencing a crisis over the past decade in which preexisting financial
market weaknesses were not a prominent feature. They certainly played a central role in the Asian
financial crises of the late 1990s, and financial-sector reform was a key ingredient in the IMF programs
that these countries entered. Though significant progress has been made in this regard, much remains
to be done. In particular, sometimes governmental initiatives have been launched in areas such
banking reform or corporate governance without sufficient followup. Once more stable financial-market
conditions have returned, the hard work of implementing financial-sector reform has sometimes
slackened. However, to the extent that significant financial-sector weaknesses remain, so too does the
potential for future crises.
Economic crises in emerging-market economies usually manifest themselves in the form of
financialmarket pressures, but unsound fiscal policies are frequently at the root of the problem. An
unsustainable fiscal position has often proved to be the main threat to financial stability. Fiscal
problems were an important factor in the crises experienced by Mexico and Russia in the second half
of the 1900s and by Argentina currently. If market participants come to perceive high levels of
government debt and continuing fiscal deficits as threatening a government's ability or willingness to
meet its debt obligations, capital flight can be triggered. When the government's fiscal position is truly
unsustainable, international financial assistance aimed at providing temporary liquidity will not suffice,
and some form of debt restructuring becomes unavoidable. Thus, a sound fiscal position is as
important as a healthy financial sector in preventing emerging-market financial crises.
We must be realistic about the feasible pace of improvement in economic policymaking in many
countries. Economic institutions and practices take a long time to develop--they cannot be put in place
or changed radically overnight. Furthermore, as I argued previously, efforts to introduce policies that
open an economy to international markets before the appropriate legal and institutional infrastructure
is in place--for example, taking all controls off short-term capital movements when the banking system
is underdeveloped and inadequately regulated--can be counterproductive. Thus the importance of
sequencing--of coordinating the timing of policy reforms with the evolution of supporting institutions.
Some of the changes in the international economic environment in recent years appear favorable to a
reduction in the likelihood of financial crises in emerging-market economies. Although it is difficult to
generalize, macroeconomic policymaking in emerging-market economies seems to have improved
somewhat in recent years. The trend toward adoption of more flexible exchange rate regimes has
already been mentioned. Also, over the past decade policymakers in emerging-market countries seem
to have developed a heightened recognition of the costs of high inflation, as evidenced by the general
reduction of inflation rates in such economies over this period. The behavior of investors in
international capital markets appears to have evolved in ways that make future financial crises
somewhat less likely also. The composition of international capital flows has shifted toward relatively
more foreign direct investment and longer-term portfolio investment and relatively less flows into
shorter-term "hot money" investments. Also, international investors seem to be differentiating more
clearly among emerging-market economies, as indicated by the current wide dispersion of debt
spreads across countries. This situation could mean less potential for serious contagion if one country
gets into trouble, since there would be a reduced tendency to treat all emerging-market countries alike.
The so far minimal financial market spillover to other emerging-market economies from the current
difficulties in Argentina and Turkey is consistent with such a trend. Furthermore, to the extent that
international investors have differentiated am