Mervyn King: The international financial system: a new partnership
Speech by Mr Mervyn King, Deputy Governor of the Bank of England, at the 20th Anniversary of the
Indian Council for Research on International Economic Relations, New Delhi, 9 August 2001.
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Introduction
It is both a great honour and a real delight to make my first visit to India in order to commemorate the
20th Anniversary of ICRIER. I feel especially honoured to be invited to deliver the first K. B. Lall
Lecture. The theme of my lecture will be the international financial system, and the need for a new
partnership between those countries exporting capital, in normal circumstances the developed
economies, and those countries which import capital, the emerging market economies. The
international financial institutions set up at Bretton Woods over 50 years ago were designed to deal
primarily with problems of current account imbalances. In recent years, however, major financial crises
have originated in the capital account. Why have these occurred, and how can we make them less
likely in future and improve our ability to deal with them when they do occur?
I can think of no better place to discuss this subject than ICRIER. The links between international flows
of private and public finance, and the need for a restatement of the role of the international financial
institutions and a clearer understanding of their modus operandi, are subjects at the heart of the work
of ICRIER. Your Founder Chairman, Dr K B Lall, whom I am delighted to say is with us this evening,
worked tirelessly over the years in so many areas of international economic policy, including a period
as Chairman of the General Agreement on Tariffs and Trade. Your current Chairman, Dr I G Patel,
served India not only as Governor of the Reserve Bank but also at the International Monetary Fund. It
is a great personal pleasure to see I G, as we all know him, here tonight because I owe him a great
debt for his help and support at the London School of Economics during his period as Director in the
1980s. And the new Independent Evaluation Office of the IMF, an important development in improving
the accountability of the Fund, will be led by Mr Montek Singh Ahluwalia, one of India's most
distinguished economists, and the husband of your Director, Dr Isher Judge Ahluwalia.
India was one of the 44 countries which participated in the meetings at Bretton Woods which led to the
creation of the International Monetary Fund and the World Bank. The Bank of England archives
contains some fascinating material on the Bretton Woods Conference and, in particular, on the role of
the Indian Delegation. Sir Chintaman Deshmukh, the Governor of the Reserve Bank, was reported to
have made a big impression on the delegates at Bretton Woods. A cable from the Foreign Office to the
British Embassy in Washington on 1 June 1944 argued that there were strong grounds for giving India
a seat on the Agenda Committee. The reply reported US opposition to this idea, in part because
Canada and Australia were already represented on the Committee. The resulting compromise was the
product of bureaucratic genius. An Indian representative was allowed to participate on the Committee
provided that there was no public announcement of the fact. In the end, common sense prevailed and
India received an official invitation to attend the Agenda Committee.
Recent international financial crises
Perhaps the key difference between the world of Bretton Woods and the world today is the size and
volatility of private capital flows. Then, as now, it was recognised that no system could ensure the
compatibility of:
(i) Domestic monetary autonomy;
(ii) Stable exchange rates;
(iii) Free capital mobility.
This "impossible trinity" has been at the heart of the debate on the international monetary and financial
system for many years. A sustainable system must sacrifice one of these three objectives. Some
countries have decided to abandon the first leg of the tripod, namely domestic monetary autonomy. In
Europe, twelve countries have formed a monetary union, and elsewhere, such as in Argentina and
Hong Kong, currency boards, linked to the dollar, have replaced discretionary monetary policy. Other
countries have abandoned the attempt to maintain rigidly fixed exchange rates, and adopted a
combination of domestic monetary management based on an inflation target and a floating exchange
rate. Examples include both developed economies, such as the UK and Canada, and emerging
market economies, such as Brazil and South Africa. There are arguments for and against both of
these approaches. But what is clear is that both in theory and practice there is now a recognition that
pegged (fixed but adjustable) exchange rates do not provide a viable long-term middle course. More
interesting, perhaps, is the absence of serious debate on the merits of the third position, namely the
willingness to forego freedom of capital movements in order to retain domestic monetary autonomy
and stable exchange rates. That is perhaps surprising in the light of the experience of the two major
countries in Asia that escaped the financial crisis of 1997-98, namely India and China, which had in
common the presence of capital controls.
The willingness to impose controls on capital movements, at least temporarily, was certainly evident at
the Bretton Woods Conference. Mindful of the weakness of Britain's national balance sheet, Lord
Keynes, urged on by the Bank of England, argued that there should be no legally binding obligation to
make the sterling balances convertible into dollars. The vulnerability of countries to financial crises
when private capital is freely mobile was uppermost in the mind of officials then, and has recently
returned to prominence in the wake of recent crises.
Capital flows do, however, bring real economic benefits. They enable savings from around the world to
move to those countries with the most profitable investment opportunities, benefiting lenders and
borrowers alike. And such capital flows also transfer knowledge and expertise. The most important
task of any financial system is to guide the allocation of scarce capital. As Larry Summers, the former
US Treasury Secretary, said earlier this year, "If you are looking for reasons why some countries
succeed and why other countries do not succeed in the new global economy, a very large part of it
goes to the greater success of the successful countries in channelling capital into the right places, and
then making sure that it is used in a disciplined way."
At Bretton Woods it was thought that post-war reconstruction could be financed by capital provided by
the new World Bank, the twin of the International Monetary Fund. Hence it would be possible to
finance reconstruction from long-term investment supplied by official institutions, without the necessity
of allowing free movement of private capital that might raise the problem of the "impossible trinity".
Soon, however, the demand for capital imports exceeded the ability of international institutions to
supply loans. Private capital markets came into their own. The expansion of private capital flows was
gradual, and, until about ten years ago, was primarily concentrated on flows among the developed
economies. It is only in the past ten years that the explosion of private capital flows to emerging
market economies has taken place. Data from the World Bank suggest that annual capital flows to
emerging markets were less than $10 bn in the early 1970s, rising to around $300 bn in the late
1990s. At their peak, capital flows to emerging markets were around 5% of those countries' GDP.
Unfortunately, capital flows on this scale can reverse themselves as suddenly as they appear. The
result of such sudden and large reversals of short-term capital flows has been a series of international
financial crises, in Mexico in 1994-95, Asia in 1997-98, Brazil in 1998-99, and, more recently in Turkey
and Argentina. The frequency and scale of these crises, if they were to continue, would be a serious
impediment to the evolution of the international capital market. Unless we can both reduce the
frequency and severity of such crises, and improve our techniques of crisis resolution, then the
demonstrators against globalisation will be provided with unnecessary ammunition.
The costs of recent crises have been large. Between 1996 and 1998, the reversal of private capital
flows to the five Asian countries primarily affected (Indonesia, Korea, Malaysia, the Philippines and
Thailand) was almost $150 bn, equivalent to about 15% of the pre-crisis level of GDP. Changes in the
capital account imply equal and opposite swings in the current account. Inevitably, a change in the
current account on that scale is likely to mean a deep recession. And during the Asian crisis, real GDP
fell by 1% in the Philippines, 7% in Korea and Malaysia, 11% in Thailand and by 13% in Indonesia.
Several years of economic growth were wiped out, leading in some cases to political instability. A
recent study by Robert Barro shows that countries that experience financial crises can expect to return
to their pre-crisis rate of economic growth only after about five years on average. Although the
recovery of the afflicted Asian economies in 1999-2000 was more rapid, the fall in investment is likely
to affect their level of output for several years.
It is clear, therefore, that it is dangerous for countries to sail unprepared into the deep waters of
international capital markets. One of the important lessons of recent crises is that not all capital flows
are equally dangerous. Most of the reversals in capital flows to the Asian countries were in the form of
swings in short-term debt finance - about 80% resulted from changes in the net flows of finance from
commercial banks. A build-up of short-term debt creates vulnerabilities in a country's national balance
sheet. Where there are significant mismatches in either maturity and currency obligations, then a
country is vulnerable to a liquidity run. In such a situation sudden reversals of capital flows can occur
on a huge scale. That is the hidden cost of debt finance. In contrast, equity capital does not involve the
risk of crises that are associated with the possibility of interruptions to payments on debt finance. This
is because equity investment has a self-stabilising mechanism. Investors cannot withdraw from the
equity market without finding a buyer to replace them. The market price adjusts in order for the seller
to attract a buyer. Of course, the market price may move sharply and rapidly, and impact spending
decisions. But crises resulting from payment interruptions are a feature of debt finance. Lenders
whose bonds mature or who choose to withdraw their deposits do not have to find a buyer. Instead
they simply exit, and, if they do so on a sufficiently large scale, countries can find themselves facing a
liquidity run.
Interest rates on lending to a country vulnerable to a run can rise to extremely high levels. If the
market anticipates that a country may allow inflation to rise, or the exchange rate to fall, to alleviate the
burden of domestic currency debt then interest rates on debt can rise rapidly. It is only ten years ago
since overnight interest rates of several hundred percent were seen during the ERM crisis in Europe.
But even on foreign currency borrowing, a country may find that the spread of the interest rate at
which it can borrow over the interest rate charged to "safe" countries, such as the United States, can
reach extremely high levels. And where that interest rate is markedly higher than the growth rate of the
economy, the debt burden rapidly becomes unsustainable unless the interest rate can be brought
down quickly. Before the Russian default and devaluation of 1998, the average spread on emerging
market sovereign debt was around 500 basis points, in itself a sizeable addition to the burden of
borrowing in international capital markets. That spread then rose sharply to levels of between 1000
and 1500 basis points. At these levels debt burdens were clearly unsustainable. Since then,
macroeconomic reform in many of the affected countries, with the help and support of the IMF, has
reduced average spreads to a range of between 600 and 800 basis points, although there has been a
further rise recently following the difficulties in Turkey and Argentina.
Emerging market spreads are currently around 900 basis points over interest rates on US Treasury
bonds. It is not easy to reconcile spreads at this level with the fact that sovereign debt defaults on
bonds are running at historically low levels. In part, the low level of defaults may reflect the increase in
the number of exceptionally large loans made by the IMF in recent years. So what does account for
the high level of emerging market spreads? There appears to be a good deal of uncertainty
concerning the conditions surrounding the availability of official finance. It could be that investors are
demanding higher interest rates to compensate for that uncertainty. There is also uncertainty among
market participants about what would happen in the event of a debt restructuring and the expected
repayments that would ensue. One role for the official community is to try and mitigate these
uncertainties through greater clarity about the criteria for official lending and its crisis resolution
policies - a theme I return to below. If successful, one outcome of these reforms would be lower
borrowing costs for emerging markets.
Investors are also starting to differentiate among borrowing countries more clearly than before. This
has led to a greater dispersion of spreads on emerging market debt. Before the Russian crisis these
spreads were tightly compressed with the central 50% of the distribution of emerging market spreads
covered by a range of only around 100 basis points. At present, the range covered by the central 50%
of the distribution is over 500 basis points. Correspondingly, there has been a sharp fall in the
correlation between changes in emerging market spreads. The rolling 26 week correlation between
changes in emerging market spreads reached a peak of around 0.8 at the time of the Russian crisis.
Since then it has steadily declined, reaching a level of only 0.2 before the recent rise to around
0.35 following adverse developments in Turkey and Argentina. This differentiation in spreads is a
welcome development. It shows that the possibility of contagion from a country affected by a crisis to
others initially unaffected is less than might have been the case only a few years ago. Of course, if a
country did default then correlations might rise significantly, but the focus of attention on recent crises
and their causes has led investors to appreciate that many have been country-specific. Although there
is no room for complacency, the lower correlation of spreads and the greater differentiation of risk
assessments represents an increase in the efficiency in the way capital markets operate.
The experience of recent crises prompts two questions. First, what can countries do to protect
themselves from the risk of further financial crises? Second, what should be the responsibility of the
international community towards emerging market economies?
A new partnership
In describing a new partnership between emerging market economies and developed economies, it is
useful to distinguish between measures to improve economic performance and prevent financial
crises, on the one hand, and ways to resolve crises once they have occurred, on the other. In this
section I deal only with the former. Crisis prevention should be at the heart of the policies of both
emerging markets and the international financial institutions.
In terms of prevention, recent experience suggests five lessons for the future.
1. First, it is important that borrowing countries, especially those without a track record of
international borrowing, monitor and manage the maturity and currency composition of their
national balance sheet. This is not a trivial matter. Most countries have inadequate
information on the composition of their external liabilities, especially those of the private
sector. Nevertheless, monitoring and managing the exposures of the public and financial
sectors are important to avoid a build up of potential vulnerabilities. In this respect, the IMF
can play a helpful supportive role by providing assessments of vulnerability as part of the
Article IV process, the new joint IMF/World Bank financial sector assessment programmes
and debt management guidelines, and technical assistance on the data requirements implied
by the need to monitor national balance sheets.
2. Second, limitations on official finance mean that countries should think carefully about the
provision of self-insurance against a liquidity crisis. A simple, but often expensive, way to do
this is to build up large foreign currency reserves, a strategy taken to heart by a number of
emerging markets, including China and also Korea following its crisis. A potentially superior
alternative is the creation of contingent credit facilities with both official and private sector
creditors. So far, even at the high spreads on emerging market debt, these facilities have not
proved attractive, and the CCL facility created by the IMF has lain dormant. The next few
years will be a test of the value of such facilities.
3. Third, experience has shown the value of borrowing countries establishing good
relationships with creditors well before any possibility of difficulty in repayment arises. The
creation of investor relations programmes and the regular briefing of creditors about
developments in economic policy can play a role in providing the information which the
market requires to assess the riskiness of sovereign loans. It is never too early to build a
relationship with actual or potential creditors. The IMF, in collaboration with the private
sector, have recently drawn up a set of guidelines that countries might usefully follow when
setting up an investor relations programme. The second aspect of relationships with
creditors is the insertion of collective action clauses in sovereign debt contracts. This
proposal, advanced originally in a G10 Deputies' report in 1996, has gradually become
accepted as a sensible step forward. The UK has introduced collective action clauses into its
foreign currency debt instruments. And just last month, the G7 Finance Ministers agreed on
the importance of introducing collective action clauses into debt contracts to facilitate crisis
management. Again, time may be on the side of reform.
4. Fourth, in the long run, the best way to avoid the problem of liquidity crises is for the
composition of capital flows to emerging markets to move away from debt, both bank and
bond, finance towards portfolio equity and direct investment. Shocks to the borrowing
country would take the form of a fall in equity prices, not a liquidity run with its associated risk
of a financial crisis and the need for external finance. Encouragingly, the pattern of capital
flows to emerging markets is already evolving in that direction. Bank lending represented
around 80% of capital flows to emerging markets during the 1970s. But by the end of the
1990s, FDI accounted for around 80% of emerging market capital flows, with portfolio equity
accounting for much of the remainder. As Ken Rogoff, the new Economic Counsellor to the
IMF, pointed out in 1999 there are still several biases towards debt rather than equity finance
in capital flows to emerging markets. One of these is deposit insurance in both creditor and
debtor countries which makes it more difficult for the authorities to avoid being seen as
providing some implicit support to international loans by domestic banks. There is no easy
answer to this problem, but a shared concern in both borrowing and lending countries is the
implicit insurance which both sides are giving to large parts of the financial system. The
moral hazard so created is not restricted to international lending, but it does affect the
incentives for the form of investment in emerging markets. We need also to guard against
institutional or regulatory mechanisms - both international and domestic - which favour
short-term over longer-maturity capital flows. In the long run, the solution is for emerging
markets to create legal structures and a stable economic policy environment that provide the
confidence to support inward equity investment in their economies.
5. Finally, greater transparency allows better informed decisions by both borrowers and
lenders, and reduces the risk of contagion by allowing markets to differentiate among
borrowers. Much has been said, and, more importantly, achieved in the area of transparency
in recent years. There has been an explosion of codes and standards on different aspects of
economic and financial policy in recent years. So much so, that some countries are claiming
that the process needs to slow down. It is certainly important to recognise that the
appropriate codes and standards for a country at one stage of economic development may
not be appropriate to countries at other stages. I say advisedly "may", because in each
individual case the argument has to be made. But if it is accepted that codes and standards
are likely to reflect different stages of development, then it is even more important that
countries make clear to which codes and standards they are actually adhering. That is why
countries should not be able to opt out of "transparency about transparency". Following the
production of pilot transparency reports on a number of countries, including the UK and
Argentina, the IMF has now made rapid progress in producing reports on the observance of
standards and codes (ROSCs). As of April 2001, 110 ROSC modules had been completed
for 43 countries, of which 76 have been published covering 31 countries. India has recently
had a ROSC published on fiscal transparency. It is critical that monitoring of the observance
of standards and codes be fully integrated into IMF surveillance under Article IV. Here
implementation is urgent.
In the field of transparency, the key elements of the new partnership are, first, a commitment by
emerging market economies to implement transparency about transparency by publishing ROSCs,
and, on the part of the international community, new opportunities for emerging markets to engage in
the process of constructing and developing codes and standards. There is encouraging evidence of
greater collaboration and consultation between developed and developing countries in the design and
implementation of the core standards - for example, on banking, securities and insurance regulation,
data, payment systems, insolvency and transparency of monetary, fiscal and financial policies. That is
all to the good and there is further to go. It is crucial that we find new ways of involving emerging
market countries in the process of designing and implementing standards and codes.
In this area, ownership is all. Transparency cannot and should not be imposed on any country.
Countries themselves benefit most from being transparent and releasing the reports of assessments
by the IMF about their financial systems. And the enthusiastic embracing of transparency by a number
of emerging markets has paid off in terms of better relations with creditors. Ultimately, the most
successful route to enhance the influence of emerging markets on the development of standards and
codes is to strengthen the role of the IMF and the World Bank, the twin institutions that can claim
legitimacy through the membership of 183 countries. Under British Chairmanship, efforts have been
made to increase the effectiveness of the meetings of the IMFC which represents all countries around
one table.
Private finance and public funds
The second main area in which further progress is required is the resolution of crises. The problem
would be easier to solve were it possible to distinguish between two rather different sources of
crises - a liquidity-based problem caused by a currency or maturity mismatch in a country's national
balance sheet despite a sustainable macroeconomic and debt position; and a fundamentals-based
problem which means that the debt burden is unsustainable or the exchange rate or other key
macroeconomic policies need to be altered. In the former case, the provision of liquidity support by the
international community might help to bridge to a position in which the country could re-engage with its
private creditors. In the latter case, the main requirement is not liquidity support but a change in
macroeconomic or debt management policies. Recent crises have seen examples of both types of
problem.
Liquidity runs typically occur because of a co-ordination failure among creditors. There are two
solutions to this co-ordination problem. The first is a lender of last resort that is able to provide liquidity
support quickly and on a large - indeed, potentially unlimited - scale for a short period to enable the
affected country to meet its obligations. Such loans would normally be short-lived, and should be
made available at an above-market interest rate such that this sort of finance is seen as last not first
resort. The second solution to the co-ordination problem is for the borrower to impose a temporary
suspension of payments to create a "time out" during which the borrower can negotiate directly with
the creditors, and so arrange a new profile of repayments of debt. Both approaches, if understood and
implemented consistently over time, can provide an efficient solution to the co-ordination problem and
eliminate the incentives for a liquidity run.
But, as Ken Rogoff pointed out in 1999, the lender of last resort approach carries with it the risk of
introducing significant moral hazard into the loan market. If lenders believe that sovereign borrowers
are likely to be bailed out, then their incentive to assess the riskiness of their loans will diminish.
Equally, borrowing countries will find it more attractive to claim that the measures necessary to
continue servicing their debt are "politically impossible" if they believe that there is an international
deep pocket willing to extend loans and defer the moment when the national balance constraint is
binding.
There are two good reasons for the IMF not being able to play the role of an international lender of last
resort, at least for the foreseeable future. First, the moral hazard created by both lenders and
borrowers cannot simply be assumed away. It is not easy to quantify, but it is noteworthy that the
number of sovereign defaults has declined quite sharply during the 1990s. If sovereign risk is
mis-priced by private capital markets, this sows the seeds of future crises. The increased provision of
official finance would proceed hand-in-hand with an increased incidence of crises.
Second, to be effective, a lender of last resort must have the ability to extend sufficient resources that
the market has no doubt whatsoever about the ability to provide whatever it takes to deal with the
immediate crisis. The IMF is not in that position. There is no political commitment to provide the IMF
with unlimited funds. As the finance ministers and central bank governors representing all IMF
member countries said in their communiqué of the IMFC last September in Prague: "The Committee
notes that Fund resources are limited and that extraordinary access should be exceptional ...".
In practice, however, exceptional access has often been more the norm in recent years. Normal
access is typically defined as 300% of IMF quota. During the Asian crisis, Korea's programme was
almost 2000% of quota and Thailand's over 500%. More recently, Turkey's programme was over
1500% of quota and Argentina's 500%. If creditors and debtors continue to believe that exceptional
access is readily available, then international credit will be over-extended and the incidence of crisis
will increase.
One reaction to these extremely large packages - "bailouts" - and the accompanying moral hazard is
simply to say that the official sector should have no part to play in what is essentially a private
international capital market. Official lending is now small relative to private capital flows. Over the last
three years, private flows have been around 7.5 times greater than official flows, according to IIF data.
Against that backdrop, some have argued that the IMF should be abolished. This would be to throw
out the baby with the bath water.
What is needed is a "middle way" between full IMF insurance and no insurance at all. This middle way
would comprise IMF lending but within strong presumptive limits. A key principle underlying this
approach is that the international community needs to set out as clearly as possible the criteria that will
govern the size and scope of IMF lending. Since most agree that there are limits on IMF lending, there
is merit in explaining those limits to both potential borrowing countries and their private creditors. This
would enable debtor countries better to plan their policies. It would also allow creditors to assess risk
more accurately. Indeed, put more controversially, how can sovereign risk be accurately assessed
without clarity about the Fund's role? A lack of clarity about the likely response of the international
community to potential crises is a recipe for inaccurate assessments of risk. Such uncertainty would
add to the (already high) cost of borrowing by emerging markets.
So far, the "middle way" seems a statement of the obvious - namely that there are limits to IMF
lending and that there is merit, for debtors and creditors, in having clarity about those limits. The other
side of this coin is that, on occasions, there will be countries that have run up unsustainable debt
burdens, or face severe liquidity pressures, and who have little alternative but to restructure or
reschedule their debt. Perhaps this is why the international community has moved significantly in the
direction of giving "private sector involvement" a greater role in the resolution of financial crises than
was typically the case in the late 1990s. The IMF communiqué in Prague last year, the G7 Finance
Ministers statement last month, recent joint work by the Bank of England and Bank of Canada, and,
significantly, speeches by the new Managing Director of the IMF, Horst Kohler, have all emphasised
the need to move further in the direction of greater private sector involvement. As one example the
Report of the G7 Finance Ministers to the Heads of State and Government only last month stated that,
"While the IMF has an essential role to play, official resources are limited in relation to private financial
flows. The engagement of private investors is thus essential for the resolution of payment imbalances
in crises... the official sector needs to avoid creating expectations that private creditors and investors
will be protected from losses or that official resources would be used to finance large, sustained capital
outflows. ... We underscore the need for further progress".
The opponents of this approach raise two important questions. First, is it possible to define limits on
IMF lending? Second, is it acceptable for the official sector to countenance default by a sovereign
borrower when the consequences for both the country and the international financial system could be
devastating? I shall try to provide answers to both of these questions.
It is true that recent crises have been the result of developments in the capital account rather than the
current account. As capital flows have grown, so too have the potential demands on the official
community as they attempt to fill capital account financing gaps. That is why so many more
programmes have involved "exceptional" access in relation to quota. So perhaps, in a world of capital
account crises, exceptional access should become the norm?
This argument is superficially quite attractive. But its implications need to be assessed carefully. It
would mean that IMF resources would need to increase in line with private capital flows even for the
IMF to maintain its current role. And since 1970, capital flows have grown around four times as fast as
world incomes. The share of world GDP devoted to resourcing the IMF would grow rapidly over time.
In fact, as private capital markets came to understand this, the scale of private capital flows could
increase to an even greater extent. Private creditors and debtors would accumulate ever larger
bilateral debts, safe in the knowledge of a multilateral insurance mechanism. The logical end point of
th