The Challenges facing Developing Countries in their International Relations
8. The Developing Countries and the International Financial Architecture
Ngaire Woods, University College, Oxford
Abstract: The 1990s have been marked by a series of crises that pose a serious challenge to the international financial and monetary system. The recent debate on the international financial architecture is a response by policy-makers to this challenge. This presentation explores the implications of the debate for developing countries. It examines the implications of what is being done in the aftermath of the crises, and also what is not being done. It acknowledges that policy measures articulated in the course of the debate are a significant improvement on prevalent orthodoxy. However, the participation of developing countries is essential for the maintenance of international financial stability, and much remains to be done in this direction.
International financial crises have been a recurrent theme in the 1990s. The ERM crisis of 1992-93, the Mexican peso devaluation or the Tequila crisis of 1994-95, East Asia in 1997, Russia in 1998, Brazil in 1999, the collapse of the Long Term Management investment fund in the US – the list is a long one. Irrespective of their immediate causes, the crises demonstrated four problems of the world economy that afflict particularly the developing countries. These four problems are:
- the perils of short-term flows – E.g. flows dropped from US $75.6 billion in 1996 in East Asia, to US $-52.2 billion in 1998 (IIF figures). Few economies, however stable, could sustain such a swing. Also noteworthy, is the contrasting movement of direct equity flows, which actually remained constant or increased at the time;
- the perils of contagion – crises have tended to spread to neighbouring economies, almost without regard to their macroeconomic policies;
- the problem of intervention – Intervention has often been asymmetric, casting the most burden on the debtors and bailing out investors;
- the problem of exchange rates – The crises have increased uncertainty regarding the exchange rate policy that is most beneficial to the international monetary system.
In response to the crises and the problems described above, reform has been suggested in five policy areas.
Data Dissemination: On the basis of the assumption that the crises were a product of missing information, there is a new stress today on the importance of publishing updated accounts by borrowing governments and international organisations. Availability of information, it is argued, would enable investors to make better decisions about loans, and would also improve transparency and policy-making in borrowing governments. This new emphasis has had a positive effect on developing economies, by increasing transparency and democracy in their economic policy-making. However, the information that would have been required to avert the crises, pertains to short-term flows. The aggregation and instantaneous publication of such data is difficult and expensive even for developed countries, let alone developing ones. Further, developing countries have been the main targets for promoting data collection and dissemination. This asymmetric focus effectively reduces the burden from the private sector, which in reality shares much of the responsibility for capital flight and money laundering.
Exchange Rates and Capital Controls: The old orthodoxy had advocated a fixed exchange rate as an effective instrument against inflation. However, the danger of short-term capital flows has thrown the orthodoxy into question. Alternatives yield no obvious answers. A purely floating system may facilitate monetary policy independence and greater flexibility in response to shocks. But small open economies often lack the institutions required for the maintenance of a floating regime. Currency boards permit little monetary policy flexibility. Further, fixed rates expose the currency to speculative attacks, as was experienced by Argentina in 1999. Argentina has considered the possibility of dollarisation. US officials, however, have explicitly stated that they will not extend the safety net of bank supervision to a dollarising country. Difficulties in charting an exchange rate policy, have led to two different policy goals. One viable alternative would be to have target zones for major currencies, which would dampen the volatility faced by developing countries, or at least make regime choice easier. Another possibility would be to have temporary capital controls, such as the Chilean example of taxes on short-term capital flows. Such flows however, are difficult to administer, and lose effectiveness over time.
The nature of intervention and involvement of the private sector in workouts: In recognition of the fact that public intervention has often bailed out the private sector and created incentives for investors to make poor decisions, greater involvement of creditors in crisis management has been suggested. Various means may be used – e.g. ‘voluntary’ involvement, possibly new rules for IMF lending that would impose formulae for bail-ins. Distribution of losses between creditors and debtors, would work to the advantage of developing countries, by necessitating less severe adjustment. However, alteration of lending rules may increase the costs of loans, while compulsory bailing-in might precipitate even quicker flight. Such norms seem to work differently for countries that are too small to pose a systemic risk, such as Pakistan and Ecuador, which have renegotiated their bonds with the approval of international institutions and much agonizing in the private sector. Renegotiation for the larger developing countries will be less easy.
Setting Standards: It is assumed that financial crises will recur, as long as there is unevenness in regulation and institutions among different economies, and hence the stress on standards in the international financial architecture debate. These standards extend beyond data dissemination into areas such as competition policy, ethics, accounting, banking regulation and supervision and so forth. Most developing countries however, interpret ‘global standards’ to mean ‘US standards’. Even if there were agreement on what these ‘global standards’ might be and who would monitor and enforce them, economic and legal rules within one country would not necessarily work in another. This is especially so when the standards under discussion encroach into deep social and cultural norms in national economies. Global standards are hence, unlikely to offer a viable solution.
Reform of the International Institutions: The recent crises demonstrated clearly that the IMF (and other institutions working in related issue areas) are under-resourced and under-powered to deal with the challenges of the 1990s. Hence there has been considerable focus on increasing the Fund’s resources and making it an international lender of last resort. However, besides the logistical problem of limited resources due to lack of political will, the new role envisaged for the IMF would increase the moral hazard problem. A huge limitation of the financial architecture debate is that it has been played out in the G-22, the G-X and then the Financial Stability Forum. As a result, it has not considered the views of the majority of developing countries. Only the ‘systemically important’ developing countries have been included in any discussions. Any solutions generated thereby are unlikely to have a lasting effect, as they require the commitment and participation of developing countries for their implementation. This is especially so as many of the solutions involve reform of practices that fall within domestic legislation.
International institutions have two policy choices to increase their effectiveness. The first one is that of coercion and heavier conditionality. However, heavier conditionalities would reduce the willingness of countries to turn to the Fund, and also result in the abandonment of reform programmes as soon as possible. A heavier conditionality model would also have to be accompanied by an increase in resource assistance. The political will for such an increase in resources is however, absent among developed countries. The second, more viable option is that institutions can try to promote greater participation of developing countries, and thereby create ‘ownership’ of the policy process. To facilitate this process, developing countries will have to be given a place at the negotiating table, where they are able to define and shape solutions in accordance with their needs and evolving expertise.
In the course of the discussion, Chairperson Louise Fawcett raised the question of the reaction of developing countries to the various proposals outlined in the international financial architecture debate. The speaker pointed out that developing countries have been included only at different points in the debate and have very different interests. But even the ‘systemically important’ developing economies that have been included in the discussions, have realised that they lack bargaining power, especially when consulted in the absence of smaller members. In response to another question on why it was not enough to include just the systemically important developing countries in the debate, the speaker highlighted how the contagion effect makes it difficult to determine which economies are actually systemically important. The collapse of the baht in Thailand (not seen as a systemically important economy) precipitating the East Asian financial crisis (with systemic repercussions), illustrates the point.
(Related papers by the author can be requested)
The rest of the seminar series:
Introduction
The Politics
of Aid and Conditionality by Stephen Jones
International Investment Treaties, Valpy Fitzgerald
Good governance and the MDBs, Christina
Biebesheimer
Global Governance and the Post
Washington Consensus, Richard Higgott
Intrusive Regionalism, Amitav Acharya
Regionalism in the Middle East, Louise Fawcett
Aiding Democracy Abroad: Lessons from the late
1980s-90s, Thomas Carothers
Developing Countries
and the International Financial Architecture, Ngaire Woods
Humanitarian Intervention, Thomas Weiss