The wave of currency and banking crises that began in 1997 in East Asia generated a broad consensus that fundamental reforms were required in the international financial system.
Particularly during 1997 and 1998, the view became dominant that existing institutions and mechanisms were inadequate for preventing and managing crises in the dramatically changed world of the twenty-first century. It has become increasingly evident that achieving stability requires changes to the international financial architecture itself, though as discussed below, change at the international level has been insufficient.
Besides the objective of achieving international financial stability, an equally important objective, to which insufficient attention has been given, is the provision of adequate capital flows, both private and public, to different categories of developing economies. The two major goals for a new international financial architecture from a developmental perspective are thus: (a) to prevent currency and banking crises and better manage them when they occur, and (b) to support the adequate provision of net private and public flows to developing countries, including, in particular, low-income ones.
In this article, we attempt to assess progress on international financial reform, in relation to these two goals. In this sense, our article is broader than most of the literature on the subject, which has focused on achieving international financial stability and avoiding contagion. To the extent that private capital flows do not recover sufficiently (either spontaneously or encouraged by government policies), a greater role would need to be played by official liquidity and development finance. A particular source of concern is that an important part of this decline may be the result of structural factors such as the fact that banks have increasingly “crossed the border” by buying or establishing local banks and subsidiaries in developing countries, from which they lend in local currency (Griffith Jones 2001; IMF 2003). This would imply that net private flows to developing countries could remain very low for a fairly long time period.
Progress on international reform so far has suffered five serious problems.
First, there has been no agreed international reform agenda. In this regard, the ‘Monterrey Consensus’ of the International Conference on Financing for Development of the United Nations, held in March 2002 (see United Nations 2002), provided, for the first time, an agreed comprehensive and balanced international agenda that should be used to guide and evaluate reform efforts.
Second, the progress made has been uneven and asymmetrical in several key aspects. The focus of reforms has been largely on strengthening macroeconomic policies and financial regulation in developing countries – in other words, on the national component of the architecture – while far less progress has been made on the international and, particularly, the regional components. These are major weaknesses, as crises have not just been caused by country problems (even though these have been obviously important), but also by imperfections in international capital markets, such as herding, that lead to rapid surges and reversals of massive private flows, and multiple equilibria, that may lead countries into self-fulfilling or deeper crises.
Third, the reform effort has been focused excessively on crisis prevention and management, mainly for middle-income countries. This may have led to a neglect of the equally, if not more, important issues of appropriate liquidity and development finance for low-income countries. Moreover, the problem of availability of development finance has clearly moved to centre stage for all developing economies. Thus, although some of the reforms adopted will be crucial in the future to help prevent a new wave of crises, the problem at present is the opposite one, of insufficient private flows. This situation is likely to continue for several years. Therefore, an important task is to design measures, which will both encourage higher levels of private flows (especially long-term flows) and will provide counter-cyclical official flows (both for liquidity and for development finance purposes) during the periods when private flows are insufficient. Without this combination of private and official flows, the financial system will not be able to contribute effectively to economic growth and the achievement of the millennium development goals.
Progress has also been uneven in the realm of crisis prevention and management. In the area of crisis prevention, much work has been done in relation to strengthening domestic financial systems in developing countries and in drafting international codes and standards for macroeconomic and financial regulation, but few steps have been taken to guarantee a more coherent macroeconomic policy approach at the global level. Also, the drafting of new International Monetary Fund (IMF) financing facilities has received much more attention than international debt standstills and workout procedures. Some advance has been made in redefining IMF conditionality. The IMF quota increase and the extension of the arrangements to borrow, which became effective in 1999, has also been an advance, but several proposals made on the more active use of Special Drawing Rights (SDRs) as a mechanism of IMF financing have not led to action. Furthermore, frustration has been the characteristic of the design of the new IMF facility to manage contagion, the Contingency Credit Line (CCL).
Fourth, even some of these advances in the international financial architecture run the risk of reversal. There has been growing reluctance by developed countries to support large IMF lending (or to contribute bilateral short-term lending) to manage crises better. The main arguments given have been that these large packages lead to excessive moral hazard, which implies that both borrowers and lenders behave more irresponsibly, knowing that they will be “bailed out” and that taxpayer money from industrialised countries should not, in any case, be risked in these operations. These arguments have been vastly overstated. If progress was made on international debt workouts, this would reduce moral hazard. However, mechanisms such as international workouts, should be a complement, and not a substitute, for IMF lending in times of capital account crises.
Fifth, the slow progress in reforming the international financial architecture and the inherent asymmetry in the measures taken results in part from limited participation of developing countries in the fora where reform has been discussed, and more generally in the institutions of global financial governance. Enhancing the participation of developing countries in these institutions would imply significantly greater impulse for necessary changes in the global financial architecture. These changes, and the resulting positive impact on global financial stability and growth, would not just benefit developing countries; it would also have significant direct and indirect benefits for the developed world. A more balanced representation of developing countries in key institutions and fora, such as the IMF, the World Bank and the Bank for International Settlements (BIS) needs to be discussed in parallel with a redefinition of their functions. It is also urgent that developing countries be fully represented in the Financial Stability Forum, and in standard setting bodies, like the Basel Banking Committee, as they will be asked to implement the standards there defined.
In what follows, we examine issues relating to IMF financing facilities; world regulatory standards, highlighting problems with Basle II; international debt workouts; development finance; and regional schemes. The article concludes with thoughts on the political economy of international financial reform.
This article comes from the IDS Bulletin 35.1 (2004) Is there Progress Towards a Development‐orientated International Financial System?