Financial Crises and Reform of The International Financial System

Financial Crises and Reform of the
International Financial System
Stanley Fischer
Citigroup, New York
Abstract: Between December 1994 and March 1999, Mexico, Thailand, Indo-
nesia, Korea, Malaysia, Russia and Brazil experienced major financial crises,
which were associated with massive recessions and extreme movements of ex-
change rates. Similar crises have threatened Turkey and Argentina (2000 and
2001) and most recently Brazil (again). This article discusses the reform of the
international financial system with a focus on the role of the IMF - reforms
directed at crisis prevention, and those intended to improve the responses to
crises. The article concludes with an appraisal of what has been achieved, and
what remains to be done to make the international financial system safer.
IEL no. E5, E6, F3, F4, G1
Keywords: Financial crisis; reform of the international financial system; Inter-
national Monetary Fund
1 Introduction
The topic of the reform of the international financial system, or of the

international financial architecture, rose to prominence in the wake of
the financial crisis in Mexico in 1994-95. Interest in it intensified as
a result of the Asian financial crisis in 1997-98, and deepened following
the Russian and Brazilian crises in 1998 and 1999.
The present debate is more narrow than that on the reform o]? the
international monetary system in the decades of the nineteen sixties and
seventies. Then the issue was how to replace the Bretton Woods system
Remark: This is a slightly revised version of the Harms Lecture delivered at the Kiel
Institute for World Economics, June 29, 2002. I draw freely on Chapter 2 of my Rob-
bins Lectures presented at the London School of Economics, October 29-31, 2001,
The International Financial System: Crises and Reform. I am grateful to Prachi Mishra
of Columbia University for assistance, and to my former colleagues at the Interna-
tional Monetary Fund for their direct assistance and for many discussions over the
years that helped develop the views expressed in this lecture. Please address correspon-
dence to Stanley Fischer, Citigroup, 399 Park Avenue, New York, NY 10022; e-mail:
fischers@citigroup.com
Review of World Economics 2003, Vol. 139 (1)
of fixed but adjustable exchange rates among the major currencies, and
the role of the International Monetary Fund within the system. Now
the challenge is to reduce the frequency of crises among the emerging
market countries, the mostly middle-income developing countries that
are open to massive capital flows. In the last two years, Turkey, Argentina,
and most recently Brazil (again) have joined the list of emerging market
countries that have experienced major external crises.
In considering the reform of the international financial system, I will
first discuss reforms directed at crisis prevention, and then those in-
tended to improve the responses to crises. I will conclude by discussing
what has been done to make capital account crises less likely in future,
and the priorities for action.
2 Crisis Prevention
To reduce the probability of crises, changes are necessary in: first, coun-
try policies and institutions; second, the actions of the IMF and other
official international financial institutions; and third, the operation of
the international capital markets.
2.1 Country Policies and Institutions

Most crisis-prevention measures require improvements in a broad range
of policies and the strengthening of institutions by countries seeking to
participate in the international capital markets. I will focus on four issues:
the choice of exchange rate system; fiscal policy and debt dynamics;
capital account liberalization; and the adoption of codes and standards.
Exchange rate systems: Except for Ecuador in 1998-99 and Brazil at
present, every emerging market country that suffered a capital account
crisis in the last decade had some form of pegged exchange rate in
place before the crisis. The pegs were formal in the cases of Mexico,
Brazil, Russia, Turkey, and Argentina, and each was initially part of
a policy package to reduce inflation. The pegs were informal in the three
Asian countries, and were not the remnant of an inflation stabilization
program.
These crises reinforced the conclusion that the impossible trinity
makes a softly pegged exchange rate nonviable when the capital account
is open (see Fischer 2001a). The normal statement of the impossible
Fischer: Financial Crises and Reform
trinity is that an open capital account, a pegged exchange rate, and an

independent monetarypolicy are not consistent. If the peg is hard, such
as a currency board, then monetary policy is automatically dedicated to
maintenance of the peg. But as we have seen recently in Argentina, even
a currency board peg is not necessarily viable, for if fiscal policy goes off
track, and/or the financial system is weak, monetary policy alone may
well not be sufficient to hold the exchange rate.
A country may succeed for some time in living with the impossible
trinity, particularly if the exchange rate is undervalued. But when the
capital account is open, a pegged exchange rate is crisis-prone, vulnerable
to a speculative attack, possibly producing a second generation crisis, in
which the measures necessary to defend the peg are not politically viable.
In saying that a pegged exchange rate system is crisis-prone, I am not
claiming that the only viable system is one in which the exchange rate
floats freely. Official interventions in the foreign exchange market from
time to time can be useful, so long as they are not perceived as trying to
defend a particular rate or narrow range o f rates.
Following a float, a country has to decide what nominal anchor to
adopt, and what exchange rate policy to pursue. For a country with
a reasonable rate of inflation - one in the low double digits - experience
increasingly supports the use of inflation targeting as the basis for mon-
etary policy. Such a regime has been successfully introduced in Brazil,
Korea, South Africa, and several other emerging market countries - not
all of them recent crisis countries.
Turning to exchange rate behavior: most of the countries forced to
float have been very unhappy about the subsequent behavior of the
exchange rate, and have sought a middle way that provides more pre-
dictability for the exchange rate. It is hard not to sympathize with this
desire, both because exchange rates moved far more after the crises than
had been expected, and because there are good reasons for a country
to be concerned about the behavior of both nominal and real exchange
rates.1
Thus, monetary policy in countries with floating exchange rate sys-
tems is likely to respond to movements of the exchange rate. While this
1 Changes in the nominal exchange rate are likely to affect the inflation rate, and -
especially in countries that are to some extent dollarized - also the health of the fi-
nancial system and the distribution of wealth between debtors and creditors. Changes
in the real exchange rate affect the current account of the balance of payments, often
generating political pressures as a result.
is rarely if ever the case for the United States, it is more often so among
other G-7 countries, and for smaller emerging market economies. In
Canada, the use in the past of a monetary conditions index to guide
monetary policy, based on movements in both the exchange rate and
the interest rate, formalized the impact of exchange rate movements on
monetary policy. 2 In countries that pursue an inflation-targeting ap-
proach to monetary policy, changes in the exchange rate will be taken
into account in setting monetary policy, because the exchange rate affects
price behavior.
In the reverse direction, there is an unresolved issue about whether
monetary policy in a flexible rate system should be used in the short run
to try to affect the exchange rate. In many respects, the issue is similar to
that of how monetary policy in an inflation-targeting framework should
respond to movements in output and unemployment. Mthough it has
not received much empirical attention, there is almost certainly a short-
run tradeoff between the real exchange rate and inflation, analogous to
the Phillips curve) This is an issue that deserves serious attention, for
just as answers have been developed as to how to deal with the short-
run Phillips curve in an inflation-targeting framework, so it remains
necessary to answer the question of how in such a framework to deal
with the short-run tradeoffbetween the real exchange rate and inflation.
Recognizing the difficulty for an emerging market country of defend-
ing a narrow range of exchange rates, Williamson (2000) proposes alter-
native regimes. Rudi Dornbusch has named these BBC arrangements:
basket, band, and crawl. Williamson also recommends that countries,
if necessary, allow the exchange rate to move temporarily outside the
band, so that they do not provide speculators with one-way bets that
lead to excessive reserve losses. In these circumstances, the band is serv-
ing as a weak nominal anchor for the exchange rate, and can perhaps be
thought of as a supplement to an inflation-targeting framework. 4 Gold-
stein (2002) argues that the best regime choice for emerging economies
2 Mthough the idea behind the monetary conditions index (MCI), that both the ex-
change rate and the interest rate affect aggregate demand, is correct, the MCI needs to
be used with great caution, not least because the cause of any change in the exchange
rate needs to be taken into account.
3 Cushman and Zha (1997) contain VARs from which the implied tradeoff can be cal-
culated in the Canadian case.
4 Williamson himself believes that specifying a target exchange rate range may prevent
markets from heading off on an errant exchange rate path. Another possibility is that
by committing weakly to some range of exchange rates, the authorities make it more
is managed floating plus, where "plus" is shorthand for a framework

that includes inflation targeting and aggressive measures to discourage
currency mismatchingJ
Mthough it is not clear that this type of intermediate regime will
work for all emerging market countries, it is clear that floating exchange
rates do fluctuate a great deal, and that it would be useful if it were
possible to reduce the range of fluctuations. Some of the Asian crisis
countries have been intervening regularly and apparently successfully in
seeking to limit exchange rate fluctuations.
Outside the transition economies, countries have not succeeded in
stabilizing from high (triple digit) inflation without the use of an ex-
change rate anchor. But doing so, without an exit mechanism, is very
risky. And it is risky even if an exit mechanism is specified, as the case of
Turkey in 2000-01 shows. So I conclude that while an exchange rate peg
could be used in future to disinflate, the commitment would have to be
quite short-lived.
I believe that of all the changes in the international financial system
that have taken place since 1994, the shift towards flexible exchange rates
by emerging market countries is the one that has most reduced the risk
of future crises. However, while a flexible exchange rate regime precludes
some types of crises, external financing crises can still occur in a flexible
exchange rate regime, particularly a crisis that arises from the market's
conclusion that a country's debt situation is not sustainable - as we see
in the case of Brazil in 2002. Accordingly we turn next to fiscal policy.
Fiscal policy: The IMF's emphasis on the key role of fiscal policy in
the macroeconomic policy mix is well known to the point of caricature. 6
The discussion usually turns on the need for fiscal contraction in the
face of a variety of adverse external shocks. But sometimes, the IMF has
recommended fiscal expansions, for instance in Japan in recent years,
and after a short while, during the Asian crisis.
How should the required fiscal policy be calculated? In several pro-
grams, for instance those in Brazil, Argentina, and Turkey in the period
likely that fiscal policy will be brought into play if the real exchange rate moves too
far from equilibrium.
5 Goldstein (2002) argues that if managed floating were enhanced in this way, it
would retain the desirable features of a flexible rate regime while addressing the nomi-
nal anchor and balance-sheet problems that have historically produced a "fear of float-
ing" and handicapped the performance of managed floating in emerging economies.
6 The focus here is on the macroeconomic aspects of fiscal policy.
since 1998, the agreed fiscal stance has been guided by the need to ensure
that the debt-to-GDP ratio is put on a declining path. The well-known
equation for debt dynamics is
d = -x + (r - g ) d ,
where d is the debt-to-GDP ratio, x is the primary surplus (relative to

GDP), r is the interest rate, and g the growth rate of GDP.
If a country is in an external funding crisis because the markets are
concerned that the debt burden is nonsustainable, then the fiscal policy
will have to be such as to persuade domestic and foreign investors that
the debt-to-GDP ratio will at some point begin to decline. In a crisis, it
is likely the real interest rate will be high and the growth rate will be low,
tending to make for unsustainable debt dynamics - but also reinforcing
the likelihood that ifa credible change can be made in fiscal policy, then
an apparently unstable debt dynamics will become stable. 7
But theory has not provided a great deal of guidance about an optimal
debt-to-GDP ratio. The issue was discussed in the United States during
the period, not so long ago, when it was believed the government debt
was about to disappear. The Maastricht upper limit of 60 percent of
GDP seems to have gradually gained status as a norm. Whatever theory
ultimately emerges, it is likely that if an optimal government debt-to-
GDP ratio can be defined, it would be related to the private sector's saving
behavior. It would also be related to the terms on which the government
can borrow, and the variability of those terms, as well as the average rate
of growth and its variability.
Interest rates paid by emerging market governments are not only
higher but also vary a great deal more than those paid by industrialized
country governments. For instance, over the period 1995-2000, during
which the real interest rate paid by the United States and United Kingdom
governments had a standard deviation of 0.86 percent per annum, the
standard deviation for Korea was more than double that, and that for
Mexico and Brazil - which averaged 4.2 percent per annum 8 - greater
by a factor of five. This means that at any given debt-to-GDP ratio, the
budget of an emerging market country is more vulnerable to interest
7 This point is developedin Favero and Giavazzi (2002).

8 The underlyingdata for standard deviationsof real interest rates (quarterlydata) are
0.88 for the United States, 0.92 for the United Kingdom, 1.88 for Korea,3.66 for Mex-
ico, and 4.71 for Brazil.
rate shocks than the budget of an industrialized country. Further, the

costs of borrowing are likely to be highly nonlinear as a function of the
debt-to-GDP ratio. We have also seen in recent years, in both Russia and
Argentina, just how quickly a debt ratio can rise if the budget deficit is
large and growth is slow or negative.
The conclusion is that if there is an optimal debt-to-GDP ratio, it
must be smaller for an emerging market country than for an indus-
trialized country - equivalently, that emerging market countries that
become too dependent on the international capital markets, court great
danger. Even if it is not possible to define an optimal debt-to-GDP ratio,
it can safely be concluded that a 60 percent ratio for an emerging market
country is too high, and that ratios nearer 30--40 percent are much safer.
Capital controls: The debate over capital controls has taken on an
ideological cast that seems to have intensified during the most recent
discussions. In principle, capital controls can enable a country to have the
benefits of both a pegged exchange rate and an independent monetary
policy, and also to control both capital outflows and inflows.9
As is well known, the founders of the Bretton Woods system, re-
flecting the prevailing interpretation of inter-war experience,l~ regarded
short-term capital flows as being frequently destabilizing. The Arti-
cles of Agreement of the IMF do not make capital account liberaliza-
tion a purpose of the Fund, and Article VI permits the Fund to ask
a member to exercise capital controls to prevent the general resources
of the Fund being used "to meet a large or sustained outflow of capi-
tal."
Most industrialized countries kept capital controls in place for most
of the post-World War II period; even in the United Kingdom the last
capital account restrictions were removed only in the late 1970s. China
and India, both countries with capital controls, successfully avoided
the Asian crisis, thereby providing an important element of stability
in the regional and global economies at the time. Malaysia's imposi-
tion of capital controls and pegging of the exchange rate in Septem-
ber 1998 has attracted much attention, though evaluation of the ef-
9 Capital controls are examined by De Gregorio et al. (2000), Eichengreen et al.

(1999), and Williamson (2000); for more detailed discussion of experience with cap-
ital controls, see Ariyoshi et al. (2000).
10 League of Nations, International Currency Experience, 1944, reprinted by Arno
Press, 1978. Most of the volume was written by Ragnar Nurkse, to whom it is some-
times attributed.
fects of the controls has been difficult, since they were imposed after
most of the turbulence of the first part of the Asian crisis was over,
that is after most of the capital that wanted to leave had done so,
and when regional currency values were close to their post-crisis min-
ima. 11
Nonetheless, support for capital controls is often seen as inconsistent
with the Washington Consensus, 12 and a belief in free markets. In dis-
cussing capital controls, I shall assume that countries will in the course
of their development want to liberalize the capital account and integrate
into global capital markets. This view is based in part on the fact that the
most advanced economies all have open capital accounts; it is also based
on the conclusion that the potential benefits of well-phased integration
into the global capital markets - and this includes the benefits obtained
by allowing foreign competition in the financial sector - outweigh the
costs.13
It is necessary to distinguish between controls on outflows and con-
trois on inflows. For controls on capital outflows to succeed, they need
to be quite extensive. As a country develops, these controls are likely to
become both more distorting and less effective. They also cannot prevent
a devaluation if domestic policies are fundamentally inconsistent with
maintenance of the exchange rate.
When a country intends to liberalize capital controls on outflows,
they should preferably be removed gradually, at a time when the exchange
rate is not under pressure, 14 and as the necessary infrastructure - in the
form of strong and efficient domestic financial institutions and markets,
a market-based monetary policy, an effective foreign exchange market,
11 See Kaplan and Rodrik (2001) for a relatively positive appraisal of the Malaysian
controls.
12 The original Washington Consensus list (Williamson 1990) did not include capital
account liberalization, except for foreign direct investment.
13 The argument is developed at greater length in Fischer (1998). The point has been
much disputed, among others by Bhagwati (1998). With regard to empirical evidence
on the benefits of capital account liberalization, I believe we are roughly now where
we were in the 1980s on current account liberalization - that some evidence is com-
ing in, but that it remains highly disputed. Reinhart and Tokatlidis (2002), Chari and
Henry (2002), Bekaert et al. (2002), Galindo et al. (2002), Gourinchas and Jeanne
(2002) provide empirical evidence and discuss whether financial liberalization spurs
growth and through what channels.
14 The removal of controls on outflows sometimes results in a capital inflow, a result
of either foreigners and/or domestic residents bringing capital into the country in light
of the greater assurance that it can be removed when desired.
and the information base necessary for the markets to operate efficiently
- is being put in place. Unless the country intends to move to a hard
peg, it would be desirable to begin allowing some flexibility of exchange
rates as the controls are gradually eased. Prudential controls that have
a similar effect to some capital controls, for instance limits on the open
foreign exchange positions that domestic institutions can take, should
also be put in place as direct controls are removed.
Some countries have attempted to impose controls on outflows once
a foreign exchange crisis is already under way. This use of controls
has generally been ineffective,is It has also to be considered that the
imposition of controls for this purpose in a crisis is likely to have a longer-
term effect on the country's access to international capital.
Several countries, among them Singapore, the three Asian crisis
countries, and Malaysia, have taken steps to limit the offshore use of
their currencies. In principle, this makes it possible to break the link
between onshore and offshore interest rates, particularly by restricting
the convertibility of the currency for nonresidents - who need access
to the domestic banking system to complete their transactions. ~6 Ishii
et al. (2001) conclude that such restrictions have been more successful
the more comprehensive they have been, and that they could provide
the authorities with a breathing space in which to implement policy
changes. But as with other capital controls, their effectiveness tends to
erode over time. Further, the longer the measures are implemented, and
the stronger they are, the higher the associated costs in terms of the
efficiency of the financial system are likely to be.
Excessive indebtedness of domestic financial and nonfinancial in-
stitutions arises not from capital outflows, but from inflows, especially
short-term inflows. The IMF has cautiously supported the use of market-
based capita 1 inflow controls, Chilean style. These could be helpful for
a country seeking to avoid the difficulties posed for domestic policy by
capital inflows. The typical instance occurs when a country is trying to
reduce inflation using an exchange rate anchor, and for anti-inflationary
purposes needs interest rates higher than those implied by the sum of
the foreign interest rate and the expected rate of currency depreciation.
A tax on capital inflows can help maintain a wedge between the two
15 See Ariyoshi et al. (2000: 18-29) and Edwards (1999: 68-71).

16 See Ishii et al. (2001). This paper describes three different mechanisms that are
used to limit offshore currency trading.
10 Review of World Economics 2003, Vol. 139 (1)
interest rates. In addition, by taxing short-term capital inflows more

than longer-term inflows, capital inflow controls can also in principle
influence the composition of inflows.
Evidence from the Chilean experience implies that controls were for
some time successful in allowing some monetary policy independence,
and also in shifting the composition of capital inflows towards the long
end. Empirical evidence presented by De Gregorio et al. (2000) suggests
that the Chilean controls lost their effectiveness after 1998. They have
recently been removed.
Thus, controls can be used to help limit capital outflows and main-
tain a pegged exchange rate, given domestic policies are consistent with
maintenance of the exchange rate. However, such controls tend to lose
their effectiveness and efficiency over time. Capital inflow controls may
for a time be useful in enabling a country to run an independent mon-
etary policy when the exchange rate is softly pegged, and may influence
the composition of capital inflows, but their long-term effectiveness to
those ends is doubtful. In a nutshell: capital controls may be useful, need
to be exercised with care, are likely to be transitional - albeit possibly in
use for a long time - and caution is necessary in removing them.
A capital account amendment to the Articles of Agreement of the
IMF was on the agenda at the annual meetings of the IMF in Hong
Kong in 1997.17 Given recent controversies about capital flows, it is no
longer on the agenda. But it should be. The Fund should have the orderly
liberalization of the capital account as one of its purposes. Just as is
the case with current account liberalization, countries could elect to
maintain capital account restrictions (the equivalent of Article XIV of
the Articles of Agreement), and, when ready and willing, could accept the
obligations of an open capital account (the equivalent of Article VIII).
What benefits would this bring? For countries, it would provide
a framework in which to think about their present capital controls,
possibly to rationalize them, and eventually to undertake capital account
liberalization. For the Fund, it would put center stage a set of issues that
is critical to the operation of the international capital markets and the
frequency of crises. And for the Fund and the economics profession, it
would make it necessary to develop a body of knowledge about capital
17 The Interim Committee agreed in April 1997 that there would be benefits to
amending the Articles of Agreement to make capital account liberalization a purpose
of the Fund, and to extend the Fund's jurisdiction to capital movements.
Fischer: Financial Crises and Reform 11
account restrictions and how best to remove them. It is striking that

while accepted principles exist for current account liberalization - for
instance, first replace quantitative restrictions by tariffs, then gradually
reduce tariffs and their dispersion - we have few established principles
about the removal of capital account restrictions. While many - myself
included - believe that the capital account should be liberalized at the
long end first, that there should be few restrictions on foreign direct
investment, and that Chilean-style inflow controls can be useful, these
views do not cover all capital account issues, and in any case need further
substantiation and refinement.
The adoption of codes and standards: In considering systemic reforms
after the Mexican crisis, the initial reaction was to emphasize the need to
provide better information to the markets. The Special Data Dissemina-
tion Standard (SDDS), introduced in 1996, was developed in response.
It describes a set of data, and information on procedures for their release,
that subscribing countries have to meet. At present 50 countries have
subscribed, including most emerging market countries. The General
Data Dissemination System (GDDS) was developed subsequently for
countries that do not yet aspire to meet the SDDS; it sets out procedures
by which participating countries can gradually improve the quality of
their data, with the assistance of the IMF.
Probably the most important improvement made under the SDDS
is to bring uniformity to the release of information on reserves. The
reserves template requires countries to make data on reserves available
at least monthly, with no more than a one-month lag. is' 19 Data on
forward commitments have to be revealed. The requirement to provide
external debt data is also extremely important - one of the main tasks
the IMF found itself undertaking in its meetings with the private sector
immediately following the outbreak of a crisis was trying to reconcile
different external debt estimates.
If Thailand and Korea had been meeting the conditions on the release
of reserves data before their crises, the markets would have known about
the declining reserves much sooner, and Thailand would have been
forced to reveal its forward interventions in the foreign exchange market.
18 The IMF staff would have preferred weekly data, but some leading central banks
objected. They argued that unless private sector participants were required to provide
information on their positions, the central banks would be at a disadvantage if re-
quired to provide frequent and up-to-date information on their reserves.
19 Many countries do better than this.
Each country would almost certainly have had to allow the exchange rate
to move earlier, well before exhausting their reserves. 2~ It is also possible
that, if this information had been generally available, the political system
in each country would have forced a policy adjustment on the central
bank sooner. 2I
As this discussion suggests, transparency is important not only be-
cause it provides more information to the markets, but even more be-
cause it puts constraints on what policymakers can do. Subsequently the
IMF developed Codes of Good Practices on Transparency in Monetary
and Financial Policies, and on Fiscal Transparency, respectively. These set
out standards against which countries can measure their own practices,
and where necessary, seek to improve them. The Fund helps countries
appraise their practices.
Countries' performance in meeting four standards in other areas
- the Basle Committee's Core Principles for Effective Banking Super-
vision, and standards for securities regulation, insurance supervision,
and payments systems - are assessed as part of the Financial Sector As-
sessment Program (FSAP), a joint effort of the IMF, the World Bank,
and national supervisory agencies. The World Bank is taking the lead in
assessing standards in four other areas: corporate governance (standard
developed by the OECD); accounting (International Accounting Stan-
dards Board, IASB); auditing (International Federation of Accountants);
and insolvency and creditor rights (principles developed by the World
Bank).
Each standard provides a yardstick by which a country can appraise
its performance in the relevant area, and seek to meet international
standards. The key questions then are what are the incentives and ob-
stacles to meeting the standards. The answers depend in part on how
these systems are appraised, how and to whom the information is made
public, what assistance is provided to help countries upgrade their per-
formance, and how investors take country performance in these areas
into account in making their investment decisions. Among the incen-
2o The Mexican case is more complicated, since their reserves dedined in two steps,
first followingthe Colosio assassinationin April and then in November. It is thus not
obvious that adherence to the present reserves template would have produced an ear-
lier exchange rate adjustment.
21 The report of the Nukul Commission on the Thai crisis (The Nation, Bangkok,
March 31, 1998) states that informationon reserves was very tightly held within the
Bank of Thailand.
tives should be the desire of policymakers to strengthen the economy

and reduce the probability of crisis - an incentive that should always
be present. Each country's performance in meeting a specific standard
is monitored by the relevant body, and the results are summarized in
a report on the observance of standards and codes (ROSC) that is posted
on the Internet. 22
Nothing would help improve standards more than if countries that
met higher standards were rewarded with lower borrowing costs. 23 It is
too early to tell whether spreads are lower for countries that meet rele-
vant standards. However, anecdotal evidence and discussions with some
market participants suggest that awareness of the contents of ROSCs is
growing. If this awareness translates into lower spreads for those meeting
higher standards, the standards initiative will begin to pay off both for
individual countries and for the system as a whole.
2.2 Actions by the Fund

Much of what the IMF needs to do to prevent crises - the work on
standards and codes, and the possibility of a capital account amendment
to the Articles of Agreement - has already been discussed. In addition,
the FSAP is an extremely important initiative, which is helping member
countries strengthen their financial systems. I shall focus on three areas:
improving surveillance, increasing transparency, and the possibility of
prequalification for loans.
Improving surveillance: The Mexican crisis took the IMF by surprise,
and it was easy to conclude that better surveillance would have helped
prevent the crisis - particularly because at that time the IMF did not
make much effort to monitor market and economic developments in
real time. It was only after the Mexican crisis that news and fin~mcial
data screens were widely installed in the Fund.
It is hard to quarrel with the notion that improved surveillance
should help reduce the frequency of crises, and that Fund surveillance
22 By the end of September 2001, 169 ROSC modules had been completed for 57
countries.
23 One such incentive should have been provided by the fact that to qualify for
the Contingent Credit Line (CCL) facility, a country has to be making satisfactory
progress towards meeting international standards, particularly the SDDS, the Basle
Committee's Core Principles for Effective Banking Supervision, and the Codes on Fis-
cal Transparency, and on Transparency in Monetary and Financial Policies, respec-
tively. However, the CCL has had no takers.
through the annual Article IV report, along with more frequent interim
interactions with member countries, should contribute to this end. 24
Fund surveillance has improved greatly since 1994. 25 The private dialog
between the management and staffofthe IMF and the officials of a coun-
try can be very frank indeed. Reporting to the Board is also typically very
f r a n k . 26
A key question is whether the Fund should issue public warnings -
a system of yellow and red cards - when it believes a country is heading
for a crisis. In issuing warnings of potential trouble, whether in private
or in public, the IMF has to be mindful of two types of error: the type-1
error of crises that were not predicted; and the type-2 error of a crisis that
was predicted but did not happen. It has particularly to be concerned
that its warnings may be self-justifying - and this is a difficult problem
to deal with, one that member countries tend to emphasize. Members
of the IMF Executive Board often repeat that they do not want the Fund
to become a rating agency. 27
The Fund has rarely issued a clear public warning of an impend-
ing crisis, but does express concerns that make the point. How would
it have done if it had issued public warnings? Of the six major crises
between 1994 and 1999, three were on the Fund's radar screen well
before they happened - Thailand, Russia, and Brazil - and three were
not, despite concerns having been expressed about some weaknesses
in each of the Mexican, Indonesian, and Korean economies. During
the crisis period, I predicted, within official circles, at least one cri-
sis that didn't happen. Type-2 errors of this sort are especially worri-
some. 2s
24 Given the quantity of private sector research on industrialized and emerging mar-
ket countries, the question arises whether the Fund has any advantage in undertaking
surveillance of these countries. Part of the answer should be the quality of the Fund
staff; in addition, Fund staff and management are likely to have a closer dialog with
country officials, and may well have access to better information about policies and
policy intentions.
25 In 1999, a group of experts headed by John Crow, former Governor of the Bank
of Canada, presented a report on Fund surveillance. See External Evaluation of IMF
Surveillance: Report by a Group of Independent Experts, IMF, September 1999.
26 I discuss below how such concerns are reflected in published reports.
27 The Fund publishes each quarter a list of the about 40 countries whose currencies
are usable for Fund lending; since the criterion for being on the list is to have a strong
balance of payments and reserve position, this is a rating, albeit not a very refined one.
28 If Fund warnings were self-justifying, there would not be any type-2 errors.
In addition to self-justifying predictions, it is necessary to consider

warnings that may be self-negating - warnings of a potential crisis that
induce a country to take action that averts the crisis. I have seen policy
actions taken in some economies that in my view prevented crises. In
such cases, success has many parents, and since it is the authorities
within the country who have responsibility for policy decisions, they
rightly tend to take the credit for averting the crisis. 29
While I can envisage circumstances in which the Fund should issue
public warnings - and in essence it did that a few weeks before the Thai
devaluation - the quiet approach should be the norm. Public warnings
are especially difficult when a country is in a program. If the Fund sees
a problem coming, it warns the country, increasingly urgently, that the
program is in danger. If the country does not respond, the Fund can cut
off financing, or issue a public warning, But in these circumstances, the
public warning is especially likely to be self-justifying. This dilemma is
very real, and has arisen several times in recent years.
Why do countries fail to take action when warned? For one thing, as
the late Herb Stein used to say, economists are very good at predicting
that something cannot go on forever, but are less good at saying when it
will end. (Stein's corollary is that if something cannot go on forever, it
will end.) When warning a finance minister about the non-sustainability
of the current situation, I was sometimes told that I or someone else said
the same thing a year or more ago, and we were wrong. The response
is to tell the story of the person on the way down after jumping out of
a fortieth floor window, but that usually does not w o r k - for it is rarely the
case that those being warned are unaware of the dangers they run; rather
there are usually reasons, good or bad (often political), for what they are
doing. For another thing, policymakers embarked on a dangerous policy
path tend to argue that there is something special about their ec0nomy
that makes it immune to the normal rules of economics. Sometimes
the officials concerned may believe that the trouble will come later, on
someone else's watch. And sometimes they are right to ignore a warning,
for it is wrong - but much less frequently than asserted by those being
waFned.
29 I once took an informalpoll inside the IMF asking for examples of crises averted;
there were more than l expected, even after adjustingfor multiple parentage. I am not
aware of more scientificresults on this issue.
It has sometimes been suggested that the Fund should refuse to lend
to countries that get into a crisis after ignoring warnings. The idea of
providing incentives to heed warnings is attractive, but this punishment
may be too draconian. For not only are some warnings wrong, but also,
in refusing to help a country that is willing to implement the needed
policies, the IMF would be punishing the entire population because of
the actions of a few policymakers who failed to respond to warnings -
and who have probably been fired in the meantime. There is however
a case for developing a procedure in which the terms of lending are
adjusted depending on the country's previous behavior - though there
is a delicate balance to be struck between providing incentives to heed
warnings and providing disincentives to come to the Fund when trouble
looms.
Beyond the standard traditional human intelligence aspects of surveil-
lance, the Fund has invested in the statistical analysis of vulnerability
indicators, as predictors of the probability of a crisis (see IMF 2000 and
Goldstein et al. 2000). Similar exercises are undertaken in the private
sector, and are published. While these efforts are interesting and the
results worth close scrutiny, their forecasting record is not very good;
further, to the extent that any one of these equations fits well and is
used successfully to avert some crises, it may carry the seeds of its own
destruction, in Goodhart's law or Lucas critique fashion (Berg et al.
1999).
The Fund is strengthening the vulnerability analyses it carries out
for internal purposes: these bring together the statistical analyses with
detailed country-by-country reports in seeking to identify countries that
are vulnerable, and to recommend appropriate policy measures. While
it should continue to strive to make surveillance ever better, we need
also to keep reminding ourselves that no early warning system will be
infallible.
Transparency: At the time of the Mexican crisis, the IMF published
very little about its programs, its policy deliberations, and its surveillance
activities - except for the World Economic Outlook and the International
Capital Markets Report. If the Board agreed to support a program, an
announcement of the amounts involved would be made. Program docu-
ments were not published; nor were Article IV reports.
Now the great majority of IMF members publish their Article IV
conclusions (in the Public Information Notices (PINs)) and, more im-
portant, most agree to the publication of the Article IV reports them-
selves. 3~Most borrowers release the Letters of Intent that describe their
IMF-supported programs. In addition, since the start of 2001, countries
have been allowed to publish the staff reports on programs, and about
half have been published since then. Staff papers on general policy is-
sues are almost all published, sometimes also in preliminary form to
solicit public comment. In addition, an Independent Evaluation Office,
reporting to the Board, has been established and is beginning to operate.
All this marks a revolution in transparency, and a revolution within
the Fund. At the time the changes were being debated within the Fund,
some Board members feared that greater transparency would inhibit the
frankness of the policy dialog between the Fund and its members, and
the frankness of reporting to the Board. The objection was a serious
one, even if it sometimes came from members with whom the policy
dialog was not particularly frank. It was dealt with in part by allowing
members to request the removal of market-sensitive information from
reports that were later to be published. 31 On balance I do not believe
the fears have turned out to be valid, though from time to time in
clearing a report, I was mindful of the fact that the report would be
made public.
The main argument for transparency put forward a few years ago
was that it helps make markets more efficient. That it does, despite the
difficulties skeptical markets frequently create for member countries
and for the Fund. But transparency has many other benefits. As already
mentioned, it improves policy, because policymakers operating in the
light of day cannot do some of the things they can do in the dark of
secrecy. It also improves the quality of the Fund's work, for Fund staff
and management are bound to be even more careful to get it right when
subject to s c r u t i n y - and here the Independent Evaluation Office will
also make an important difference.
But transparency does even more than that, in two regards. First,
it promotes interactions with the outside world, for as the Fund puts
information out, it has also to interact with the outside, listening to what
outsiders are saying, and taking information in. This happens in a variety
of ways: the posting of papers for comment on the web; the setting up of
30 Publication rates of Article IV's are highest for the advanced countries, Central and
Eastern Europe, and Western Hemisphere members.
31 All changes made between Board presentation and publication of a report have to
be reported in complete detail to the Board - this serves as a safeguard against changes
that do not meet the market-sensitivity test.
the Capital Markets Consultative Group, a group of private sector capital

market participants with whom general issues - but not the details of
individual country cases - are discussed; and increased interactions with
NGOs in both the industrialized and developing countries. In addition,
transparency improves the depth and the quality of the interactions
with the academic community. The Fund has to be careful in all these
interactions not to betray the trust of its members by revealing privileged
information, or by giving anyone favored access - and doing so requires
real skill and tact.
Second, transparency strengthens the potential effectiveness of Fund
surveillance over nonborrowing countries. In that regard, consider the
United States. The US government used to ignore the annual Article IV
report, and hardly anyone outside official circles got to see it. The Art-
icle IV report for the United States for 2001 was certainly not ignored:
it was the subject of many news reports and of several op-ed columns
in leading newspapers. And all the attention it received ensures the next
Article IV consultation with the United States will be treated more se-
riously by the US authorities than in the past. Of course there is also
a risk - namely that Fund surveillance fails to establish a track record.
Which is to say, transparency strengthens the incentives for the Fund to
do top-class work.
Let me confess also to a third argument that was sometimes on my
mind - that transparency probably contributes a bit to democracy.
Looking back, I regard the transparency revolution as the most im-
portant change in the IMF during the seven years I was there. This is not
simply a bureaucratic change; it is a culture change. It has some costs -
but it is overwhelmingly a positive development.
Prequalification for loans: The Meltzer Commission recommended
that the Fund move over five years towards a system in which coun-
tries would have to prequalify for loans, particularly by meeting strong
standards for the health of the banking system. 32 Loans would be dis-
bursed automatically if triggered. Other countries would not receive
loans, except in cases of systemic risk.
Relying solely on prequalification for loans would set up the right
incentives to meet the qualification conditions. However, automatic
disbursement, independent of the country's macroeconomic policies,
32 The report of the Meltzer Commission (the International Financial Institution Ad-
visory Committee) is available at <http:/lwww.house.gov/jec/imf/ifiac.htm>.
would not make sense, even if the country's overall policies had been
good at the time the line of credit was negotiated, for macroeconomic
conditions are almost bound to have changed at the time the country
needs to draw on its line of credit. Further, while there should be in-
centives for prequalification, I do not believe the Fund should refuse to
lend to nonprequalifying crisis countries - provided such countries are
willing to adjust their policies to deal with the crisis. The discussion here
parallels the discussion about the suggestion that the Fund not lend to
countries that ignore warnings provided by the Fund - and we should
note also that the Meltzer Commission's systemic risk contingency is
one that discriminates against smaller countries.
Nonetheless, the notion of prequalifying for lending is an important
one, which is embodied in the conditions for the Contingent Credit Line
(CCL) facility. The basic idea is straightforward: the IMF offers a precau-
tionary line of credit to countries that have demonstrably sound policies,
but which nonetheless believe they may be vulnerable to contagion from
crises elsewhere. In effect, it allows countries that have met certain pre-
conditions to augment - at low cost - the foreign exchange reserves they
can draw on in a crisis. The knowledge that these resources are available
may in itself deter a speculative attack. By offering qualifying countries
a seal of approval for their policies, it should also reduce contagion, by
giving less reason for investors and creditors to pull their money out
because of crises elsewhere.
The adoption of the CCL marked an important departure from the
Fund's traditional lending activities. Rather than waiting to pick up the
pieces after an accident has happened, the intent behind the introduction
of the CCL was to use the Fund's lending capacity for crisis prevention,
as well as crisis resolution. This obviously creates a risk of moral hazard.
Countries have an incentive - in theory at least - to run weaker poiicies if
they have an extra financial cushion in place. Perhaps more importantly,
investors have an incentive to lend to countries with weaker policies if
they believe that the presence of the credit line increases the chances that
they will be repaid if things go wrong.
To counter this problem, the CCL was aimed explicitly at members
with first-class policies, who would face a potential loss of access to
international capital markets because of contagion rather than domestic
policy weaknesses. But we do not live in a Manichaean world in which
we can divide countries neatly between the righteous and the ungodly.
So "first-class" should not be taken to mean "perfect." The eligibility
criteria are demanding, but not so much so that they would disqualify
any country that might benefit from signing up. 33
Unfortunately, the CCL has not been adopted by any country, and
as time goes by, it seems less likely that it will be adopted. In part this
was because of a Groucho Marx-like concern that no country that was
eligible would want to join the club. It is not clear whether a further
reformulation of the facility would lead to its use, but as of now it
seems that this important attempt to make the Fund's financial resources
available for crisis prevention has failed.
2.3 Actions by Others

Almost every suggestion for change identified so far relates to the be-
havior of the emerging market economies or the IMF. But the behavior
of the suppliers of international capital in the industrialized countries,
particularly the financial institutions, also contributes to the excessive
volatility of international capital flows, and thus to financial crises. This
is the theme of Dobson and Hufbauer (2001), who argue (p.129) that
"Changing the rules of the game in industrial countries is at least as
important as strengthening the regulators and financial institutions in
the emerging markets." This view was shared by the authorities in some
Asian countries, who attributed the crises to the behavior of hedge funds.
Dobson and Hufbauer trace many of the capital flow reversals during
crises to the behavior of short-term flows, intermediated in some way by
banks (including, for instance, providing credit to hedge funds), subject
to moral hazard caused by explicit and implicit insurance in the host
countries. Their proposed solution is a set of measures for strengthening
the new Basle Capital Accord, improving financial system regulation
in part through increasing the accountability of supervisors, tighten-
ing the frameworks governing G-10 deposit insurance, and undertaking
a review of the behavior of large portfolio investors with the goal of de-
signing "disclosure rules and other incentives that would forestall large
portfolio swings from becoming a future financial problem" (Dobson
and Hufbauer 2001: 165). They also recommend creating a clear ex ante
33 The key conditions are (i) at the time the credit line is agreed, the country is not
expected to need to borrow from the Fund; (ii) the country's economy is in good
shape, and it is making progress towards meeting relevant international standards; and
(iii) the country must enjoy constructive relations with its private creditors, and he
taking appropriate steps to limit its external vulnerability.
framework for private sector involvement in the resolution of interna-

tional financial crises, a topic to which I will turn later.
The issue here is not the goals, which are admirable, but whether
better rules and regulations can be designed. After all, the revised Basle
Accord took a considerable amount of work and time, and is only now
going into effect. With regard to hedge funds, an IMF study found that
a wide range of financial institutions, including banks, had engaged
in the same behavior as the hedge funds (Eichengreen et al. 1998).
That conclusion could point two ways, but policymakers in the leading
countries whose institutions supply funds took the view that the type
of systemic risk that emerged in the Long Term Capital Management
(LTCM) case could best be handled by greater diligence by the lenders
to hedge funds. These conclusions left the authorities in some Asian
and some European countries unconvinced, but a subsequent Financial
Stability F o r u m study 34 was not able to push towards any consensus on
the need for or possibility of greater disclosure of position-taking by
financial institutions participating in emerging markets. Although it is
doubtful that a different consensus will emerge anytime soon, this issue
should remain on the agenda.
Dobson and Hufbauer also call for better coordination among G-10
supervisors and regulators. The Financial Stability Forum (FSF) was set
up in 1999 to bring financial supervisors from the G-7 together with
their finance ministry and central bank deputies, along with represen-
tatives of the major international regulatory agencies, and International
Financial Institution (IFI) officials. As a forum, the FSF has a very small
bureaucracy, but is able to draw on the institutions associated with it,
and others, to prepare reports on major financial issues - and it has
been active in this regard, producing several good reports. Its biaanual
meetings start with a surveillance discussion seeking to identify vulner-
abilities in the international financial system, and in financial systems
in individual countries. It is not clear yet to what extent the FSF has
contributed to strengthening supervision in the international financial
system.
The G-20 was also set up in the aftermath of the Asian crisis. Its
membership is very similar to that of the International Monetary and
Financial Committee (IMFC), the ministerial level body that in effect
34 Financial Stability Forum, Report of the Working Group on Highly Leveraged Institu-
tions, Basle, 2000.
governs the I M E Given competing demands on the time of officials,

rationalization o f the proliferation o f institutions in the international
system would be desirable.
3 Crisis Response and Private Sector Involvement
While it is convenient to draw a distinction between crisis prevention

and crisis response, the line c a n n o t be clear-cut, for the way the Fund and
the international system respond to crises also helps determine behavior
before a crisis.
No issue in the debate over the r e f o r m of the system has generated
m o r e heat than that o f private sector involvement (PSI). The t e r m is used
in several senses. The literal meaning is the contribution o f the private
sector to meeting a country's financing needs. In the debate over h o w the
IMF should ensure PSI, the t e r m is often used to m e a n non-business-as-
usual ways to persuade the private sector to reduce net capital outflows
f r o m a c o u n t r y facing a capital account crisis. Some m e a n by PSI the
losses or pain b o r n e by foreign private investors during a crisis.
These different conceptions o f PSI are relevant to distinct but related
concerns about IMF lending. The first recognizes that given the scale o f
capital flows to emerging market countries, the public sector is unlikely
to be able to fully offset swings in private capital flows, and that the
private sector one way (voluntarily) or another (involuntarily) needs to
provide some o f the needed financing. 3s This leads to the second sense
o f PSI - that the IMF may o n occasion need to find ways of helping
ensure the private sector provides some o f the financing.
The third - pain - sense is relevant to the efficiency of the operation
o f the capital markets, and to moral hazard. If markets are to operate
efficiently, investors need to bear the real risks associated with their in-
vestments, and IMF programs should not shield t h e m f r o m that. 36 Oth-
35 The question of the optimal size of the IMF and of individual programs could be
analyzed using a cost-benefit analysis, in which at the margin the benefit to the global
economy of an extra dollar provided to the IMF is equal to its marginal cost. There
are of course formidable difficulties in quantifying the benefit to the global economy,
including the need to weight the gains to different groups in the global system.
36 A great deal lies behind this sentence: in particular, if optimal IMF operations can
sustainably (in the stochastic equilibrium of the system) reduce the variability of out-
put in emerging market economies, then the real risks facing investors are those in the
equilibrium in which the IMF is acting optimally.
Fischer: FinancialCrises and Reform 23
erwise moral hazard will lead investors to make decisions based on beliefs
about extraordinary rescue packages rather than a careful appraisal of
the real value of the investment. And if that happens, a successful rescue
could contain the seeds of a future crisis.
Some emphasize fairness as much as efficiency, arguing that investors
should not be bailed out by loans financed by advanced country taxpay-
ers. In fact, IMF crisis loans have always been repaid 37 - often early -
and the industrialized country taxpayers do not bear a burden. 3s Rather
the loans are repaid by the taxpayers of the borrowing country - and
accordingly many argue that investors are being bailed out by imposing
a burden on domestic residents. To clinch this argument, it would be
necessary to spell out what the alternative course of action for the cri-
sis country would have been. There would surely have been substantial
costs associated with any other course of action, such as defaulting on
the debt.
For aH three reasons - particularly because it does not have and
should not have enough money to do otherwise - the IMF has to be
concerned with private sector involvement in the resolution of financial
crises. However, the issue has to be approached carefully, lest proposed
solutions increase the frequency of crises. For instance, the formalization
of a requirement that the banks, or any other set of creditors, always be
forced to share in the financing of IMF programs, would be destabilizing
for the international system. If such a condition were insisted on, the
creditors would have a greater incentive to rush for the exits at the
mere hint of a crisis. This is a real dilemma, one that suggests the need
for a differentiated approach to involving the private sector, one that
depends on the circumstances of each country: sometimes a formal
approach may be necessary, as in Korea at Christmas in 1997; at other
times, as in t h e case of Brazil in March 1999, when the commercial
banks voluntarily agreed to maintain their lines of credit, less formal
discussions could serve better; when financing needs are small, there may
not be a need to approach the creditors; and in extreme and infrequent
cases, an involuntary restructuring of the debt may be necessary.
37 A few countries (among them Sudan, Democratic Republic of the Congo, Liberia)
are in arrears to the IMF, but these are not countries that suffered capital account
crises - rather they sufferedfrom conflict and civil wars.
38 I leave aside here the issue of whether the subsidy implicit in lending to crisis
countries at IMF rates is a burden on the providers of funds.
The IMF's approach to private sector involvement is in a state of

flux, but the framework in which it operates in practice is probably
still best described by an agreement reached among the membership
at the annual meetings in Prague in September 2 0 0 0 . 39 The approach
emphasizes the need to rely as much as possible on market-oriented and
voluntary solutions.
The basic principles of the framework are that official financing
is limited; that debtors and their creditors should take responsibility
for their decisions to borrow and lend; and that contracts should be
honored, except in extrernis. The approach taken in individual cases
should be based on an assessment by the Fund of a member's underlying
payment capacity and its prospects of regaining market access. Cases are
expected to fall broadly into four categories:
(1) Those where policy adjustment and official financing should allow
the member to regain full market access reasonably quickly. This is es-
sentially the traditional catalytic approach. The framework specifies
that extraordinary access to Fund resources should be exceptional,
and that high levels of access to Fund resources require substantial
justification, both in terms of its likely effectiveness and of the risks
of alternative approaches.
(2) Those where official financing and policy adjustment need to be
combined with encouragement to creditors to reach voluntary ar-
rangements to overcome their coordination problems.
(3) Those where the early restoration of full market access on terms
consistent with medium-term external sustainability is judged to be
unrealistic, and further action by private creditors, possibly including
comprehensive debt restructuring, may be needed in the context of
a Fund-supported program to provide for an adequately financed
program and a viable medium-term balance of payments.
(4) Those extreme cases where the member may have to resort to a tem-
porary payments suspension or standstill pending action by its cred-
itors to support the restoration of viability. In such cases, the Fund
would be prepared to lend into arrears to private creditors, provided
the country is seeking to work cooperatively and in good faith with
those creditors and is meeting other program requirements.
39See the Annex for a full statement of the relevant paragraphs. I am grateful to
Mark Allen of the IMF for allowing me to draw on material he has provided.
There are recent examples of programs in each category. The Brazil-

ian program in March 2000 fell into the second category, and it was
judged in the fall of 2000 that Turkey fell into that category too. The
Argentine debt restructuring in the spring of 2001 was perhaps consis-
tent with the third category, though full market access was not in the
end restored. And Ecuador in 1998-99, in which the IMF did lend into
arrears to private creditors, fell into the fourth category
Note that the framework does not use the words "liquidity" and
"solvency" to categorize different cases. If the distinction were being
used, cases 1 and 2 would be liquidity cases, and 4 would be a solvency
case, with 3 not clear. The distinction is not used because, although an-
alytically extremely helpful, it is difficult to apply to sovereign debtors.
For them, the distinction is largely political, for solvency depends on
the extent to which a government can or wants to reduce domestic
demand in order to continue to service its debt. For instance, follow-
ing the exchange rate crisis in February 2001, the Turkish government
faced the choice of undertaking a massive fiscal adjustment in order to
continue servicing its debt, or attempting a debt restructuring, which
would probably have had to be involuntary. It chose the fiscal adjust-
ment.
Nonetheless, four serious difficulties arise in applying this frame-
work. The first became clear following the revised Turkey program in
December 2000, after a voluntary agreement on a rollover of interbank
lines had been reached with Turkey's commercial bank creditors. At that
point the program looked likely to succeed, and the voluntary agreement
by the banks could be seen as the solution to a collective action problem.
But then during the next few months the markets' confidence in the
Turkish program began to weaken, and the banks began to pull out their
lines. 4~ Given that the program was not going perfectly, it was difficult
for the official sector to insist as strongly as before on the banks rolling
over their lines.
The second difficulty lies in the enforcement of these voluntary
agreements. In the 1980s, the authorities in the creditor countries exerted
pressure on their banks, doing so to solve the collective action problem
- namely, that if the banks agreed to provide the required amount of
funding, each bank individually would be better off than it would have
40 Part of the decline in interbank lines was a result of a decline in demand by Turk-
ish banks.
been had it done what seemed best for it, acting alone, which was to
attempt to withdraw its funds. Bank regulators have been much less
enthusiastic about exerting such pressure in recent years, for they see
a conflict between their regulatory role and their pressuring the banks to
maintain portfolio positions against their will. Some industrial country
regulators argued that it was up to the authorities in the crisis country to
persuade the banks to hold their lines. But typically the crisis country has
very little leverage in this situation. It is similarly difficult for the IMF to
exert any leverage if the industrial country regulators are not also doing
so. The key issue is whether by exerting pressure the industrial country
regulators are indeed helping the banks reach a better equilibrium - and
a judgment on that issue should be made case by case.
The third difficulty is in the notion of voluntary market-based re-
structurings of the debt. To a first approximation, a purely voluntary
market-based restructuring cannot reduce the present value of a coun-
try's debt, for the country will simply be trading the debt up and down
the term structure. 41 Thus not much should be expected from purely
voluntary debt restructurings, though changes in the profile of debt
payments - for instance pushing them out into later years - could be
useful if the country has a temporary liquidity problem. The country
could achieve a reduction in the debt burden by reducing the seniority
and thus the value of existing claims in some way. And perhaps it could
achieve some reduction in the debt burden by enhancing some new
claims with the aid of financing or guarantees from the official sector,
where the reduction in the value of the debt will be approximately equal
to the reduction in the present value of interest payments implied by
the substitution of lower interest official debt for higher interest market
debt.
The fourth, most profound, difficulty occurs in the "extreme cases
where the member may have to resort to a temporary payments sus-
pension or standstill pending action by its creditors to support the
restoration of viability." The problem is that we have no accepted frame-
work in which a country in extremis can impose a payments suspension or
standstill pending agreement with its creditors to support the restoration
of viability - and that accordingly any country contemplating a standstill
faces enormous uncertainties about what will happen to the economy if it
41 The present value of the debt could change as a result of changes in the term struc-
ture of interest.
does so. Those uncertainties are compounded by the absence of an accepted

legal framework in which the debtor and its creditors can work to seek to
restore viability.
Indeed it is striking that when governments face the decision on
whether to seek to impose a standstill and/or restructure the debt in
a nonvoluntary way, they are generally willing to go very far to avoid
a default - especially so the countries that have adopted drastic solutions
in the past, such as default, deposit freezes, and exchange controls.
A standstill could be appropriate and sufficient in a pure liquidity
crisis, as a way of stopping a self-justifying run. However, a standstill
might be the prelude to a restructuring. There is no way of knowing
until after the dust has settled. Why are countries so reluctant to go
down this road, especially given the frequency with which critics of IMF
rescues argue that a default would be better for the international sys-
tem and the country? The reasons are: that a debt restructuring will
almost certainly involve a restructuring of the domestic financial sys-
tem, where financial institutions - including banks and pension funds
- hold government bonds as important parts of their portfolios; that
it is impossible to know what interruptions there will be to the pay-
ments mechanism and to trade credit; and that it is impossible to know
when domestic and foreign confidence in the government's ability to
meet its promises will be restored, and for how long the country will
be punished by the markets for having defaulted. Rightly or wrongly,
probably rightly, debtor governments see the costs of a debt default as
extremely large and much larger than the critics of IMF loans typically
imply.
The desire of countries to avoid default raises difficult issues for the
official sector: the official sector should be on the side of those who
want to honor contracts, and should not force default on countries
that are willing to undertake the policies needed to avoid it - provided
the country has a reasonable probability of doing so successfully. But
there will be occasions when the probability of finding a way out of
a crisis without a debt restructuring and write-down is low, and it is
then that the official sector should not provide further assistance. It is
the judgment of how far to go to help a country that seeks to avoid
a default, and of what probability of success to require, that lies behind
the controversies over recent IMF support for Turkey, its decision to
support Argentina in August 2001, and not to provide further support
in December 2001.
What can be done (Eichengreen 2000)? The most important sug-

gested innovation is the creation of a legal procedure for sovereign
bankruptcy, which would require finding legal mechanisms both to ap-
prove payments standstills by sovereigns, and for the restructuring and
if necessary writing down of sovereign debts. 42'43 This is the SDRM or
Sovereign Debt Restructuring Mechanism, which has been strongly sup-
ported and advanced by my successor at the IMF, and a previous Harms
lecturer, Anne Krueger.
Should we make improvement in standstill and/or bankruptcy pro-
cedures for sovereigns a high priority? The costs of resorting to such
measures have to be high if the credit mechanism is to work well. If cred-
itors believe emerging market debtors will too easily use legal provisions
to restructure debts, spreads will rise and capital flows to those countries
will decline. That is why policymakers from emerging market countries
generally oppose proposals to make it easier for them to restructure
their payments, be it through collective action clauses or the creation of
a sovereign bankruptcy procedure.
Nonetheless, the absence of procedures for dealing with situations
where debts have a very high probability of becoming unsustainable
distorts the behavior of the international system. Under present circum-
stances, when a country's debt burden is unsustainable, the international
c o m m u n i t y - operating through the IMF - faces the choice of lending to
it, or forcing it into a potentially extremely costly restructuring, whose
outcome is unknown. I believe the official sector should go very far to
help countries that are willing to take the necessary measures to avoid
debt defaults, but debts will sometimes have to be written down. That
should be costly for the country concerned, but not as costly as it is
nOW,
Such a change in the international system would inevitably affect
the nature and direction of capital flows, and we can be sure that if
legal changes are made, the creditors will seek ways of restructuring
42 NationaI bankruptcy laws should apply to private sector debtors who carmot make
payments; if debtors can pay in local currency, the stay could permit a delay in con-
verting these payments into foreign currency.
43 It is often argued that Article VtlI-2b of the IMF Articles of Agreement could serve
as the basis for international approval of a payments standstill imposed by a member
of the Fund. However, this judgment is not shared by the IMF's lawyers, who point
out that Article VlII-2b applies to exchange controls on exchange contracts, not to
payments on debt contracts.
debt contracts to minimize the impact of the new framework. But we

could also reasonably hope that such provisions would lead to more
differentiation among countries, with flows increasing to those countries
unlikely to need to use the bankruptcy mechanism, and relative spreads
rising for those more likely to have to use it, thereby providing important
incentives to strengthen the structure of the economy and economic
policies.
So it is certainly desirable that the IMF continue its important work
on this topic. But we should recognize that at best it will take many years
to change the legal framework, and that it is quite possible that it will not
in the end be possible to persuade the U.S. Congress on this issue. In any
case, I believe the Executive Board of the IMF could make a contribution
to this effort by describing in advance a set of procedures for how it will
act if it concludes that countries have an unsustainable level of debt. This
would help formalize the approach that has already been developed on
an ad hoc basis in response to some of the recent crises. At the very least,
it would provide more clarity on the question for debtors and creditors
alike, which would be a good in itself.
The G-10 deputies' proposal for collective action clauses (CACs) in
bond contracts, which should make them easier to restructure, is another
possibility. 44 Ironically the Krueger proposal for an SDRM seems to
have achieved one important result in persuading the private sector to
support CACs. However, emerging market countries have resisted the
suggestion, arguing it would raise spreads. 45 At present some emerging
market countries are considering whether to include CACs in future
bond contracts - and if they do, that will achieve many of the goals of
a more complete SDRM.
There has been some fear that inclusion of CACs will create moral
hazard on the part of borrowers, who will be too quick to seek to
44 This proposal led to an Alphonse and Gaston act in which emerging country bond
issuers announced they would be willing to follow industrialized countries in includ-
ing such clauses, while the industrialized countries generally explained that they had
no need for them. In 2000, the United Kingdom did include such a clause in a euro
issue, in the hope that other countries would follow.
45 The strong opposition to the initial (1996) proposal for CACs became less persua-
sive when it was realized that such clauses already existed in so-called British trust-
deed bonds, and that no one had noticed. Subsequent empirical research by Eichen-
green and Mody (2000) suggested that the inclusion of such clauses reduces spreads
for high-quality borrowers and raises them for less sound borrowers - an appealing
result, though one that is the subject of ongoing research.
30 Review o f World Economics 2003, Vol. 139 (1)
restructure their debt obligations. I doubt this will happen, for the issuers
have generally fought vigorously to avoid defaults. If there is a hazard
in the adoption of CACs, it is that the official sector will become too
quick to urge restructurings as an alternative to IMF lending. There is
a balance to be struck, and it is important that the IMF not step back
from the provision of financial resources to countries facing a liquidity
crisis.
4 The Operation of the International Capital Markets
As the Mexican crisis developed, and as the Asian crisis intensified, it

was easy to conclude that the capital markets were too powerful and too
volatile, that contagion was excessive, and that they failed to discriminate
appropriately among different levels of performance. And there were
certainly occasions during the crisis when I felt that each of these charges
was justified. It was less obvious what to do about them.
One response would have been for countries to close themselves off
from the international capital markets. It is striking that despite the
blandishments of events and some well-known economists, no country
- including Malaysia, which removed almost all its controls within less
than two years after imposing them - did that. 46 Emerging market
country policymakers must have thought it useful to remain within the
international financial system despite the problems that had caused for
them.
Is there any way of establishing that the international capital markets
are inefficient? As we know from the literature on the stock market, it is
difficult to prove empirically that asset prices fluctuate excessively. 47 But
let me mention a few pieces of evidence.
Larry Summers has argued that there is an inconsistency between
the pricing of emerging market bonds and the frequency of defaults:
46 TO be sure, several countries did impose measures seeking to control or close access
to offshore markets in their currency.
47 It may be even more difficult to establish excess variability if there are multiple
equilibria. Presumably the test o f efficiency would then have seek to establish whether
the system was in a good or a bad equilibrium at any given time. There have been sev-
eral crises during which I was convinced we were in a multiple equilibrium situation,
in which the government's policies would be fully viable if spreads were lower - the
good equilibrium - but that the policies were not viable at actual spreads - the bad
equilibrium. But I do n o t know h o w to establish that was the case.
specifically, that spreads are so high as to imply a substantial probability

of default, but defaults have been few.48
Another striking fact has been the contagion that has been seen in
the emerging markets - in the Mexican crisis, during the Asian crisis,
and in the Russian crisis. However, I should add that I do not believe
the difficulties in Brazil in the run-up to the 2002 election were primar-
ily a result of contagion from Argentina; rather they mainly reflected
political uncertainties in Brazil.
There are some good reasons for contagion among related markets,
for instance, the stock prices of firms in the same industry tend to
move together, but its extent in the Russian crisis was surely excessive.
Further, the explanation that contagion spread to the stronger emerging
markets in part because emerging market traders needed cash, which
was most easily obtained in a relatively strong market, suggests a market
inefficiency in which limited liquidity in the market as a whole distorts
pricing relations among the different countries' bonds. 49
During crises, the IMF sometimes heard suggestions that a particular
course of action should be taken "for the good of the asset class" This is
not a compelling basis for making a decision on an individual country,
but it does support the view that treating emerging market bonds as
a separate asset class distorts asset pricing among emerging market
countries. Perhaps emerging market asset price determination would
become more efficient if the bonds of the different emerging market
countries were no longer treated as an asset class.
The data strongly suggest that the markets are doing a better job of
discriminating among countries now than they did during the Asian and
Russian crises. Spreads vary widely, no major anomalies in the ranking of
spreads are immediately obvious, and despite current market tensions,
several countries with good macroeconomic policies have spreads that
appear relatively low by their historical standards, for instance Mexico,
Poland, and South Africa.
Possibly we are in a period in which relative asset pricing among
the bonds of the emerging market countries is becoming more efficient,
and in which the countries with strong fundamentals, high transparency,
and good investor relations programs are being rewarded by the markets.
48 This argument is developed at greater length in Fischer (2001b).

49 Some of the explanations for contagion in the Mexican crisis also relied on the re-
balancing of dedicated emerging market funds.
But we should also remember that the overall flow of resources to the
developing countries is highly variable, and that we are once again in
a period in which gross flows are extremely low, and net flows are almost
certainly negative.
In 1997 there was much talk about there being no need for the
IFIs because the private markets were doing the job of financing the
developing countries. That was never true for the smaller less developed
countries, but the variability of private sector flows makes clear the need
for the official sector to try to offset some of the fluctuations in private
flOWS. 50
5 Concluding Comments
Paul Volcker remarked during the debate over the international financial
architecture that the proposals for reform were more like interior deco-
rating than architecture. The proposals discussed in this lecture indeed
lack the grandeur of the vision of the global economy that the wartime
generation put in place, and the issues are less important for the behavior
of the international system than those on the agenda of international
monetary reform in the 1970s. But they are critical for the emerging
market countries, and that is reason enough to treat them as matters of
the highest priority.
Those who favor a more thoroughgoing reform of the system -
including Paul Volcker - focus on the exchange rate system among the
major currencies. There is no question that such fluctuations have been
disruptive, and that changes in the yen-dollar rate contributed to the
Asian crisis - given the peg of the Asian currencies to the U.S. dollar. But
for now and the foreseeable future there is no prospect of changing the
flexible exchange rate system among the major currencies.
Would emerging market countries be better off giving up their cur-
rencies and dollarizing or euro'izing? I believe that will ultimately hap-
pen, but that for a long time, most emerging market countries will and
should continue to allow exchange rate flexibility. Had exchange rates
been flexible, most of the famous crises of the last decade would either
not have happened, or would not have taken the form they did. That is
50 The argument that IMF lending creates moral hazard implies that spreads are on
average too low. That point does not jump out of the data.
why the shift to flexible rates among the emerging market countries is the
most important change in the international financial architecture dur-
ing the past decade, which should greatly reduce the frequency of crises.
But as we see in Brazil at present, the adoption of a flexible exchange rate
regime does not prevent all external crises, for debt-sustainability crises
will still occur.
What else needs to be done? All the measures we have discussed
to prevent crises by strengthening individual economies - including
lower debt-to-GDP ratios - will contribute to the better performance of
those economies and the international system. So will lessons learned
by the IMF from the recent crises. So too should better supervision
by industrial country regulators over the financial institutions active
in international markets, and more provision of information by those
institutions.
The major unresolved issue is the framework for private sector in-
volvement. Sometimes countries, like companies, need either a pause
in their debt servicing (in a liquidity crisis) or a permanent reduction
in the burden of debt servicing (in a solvency crisis). The international
financial system will not work well unless the imposition of a standstill
or debt reduction is extremely costly to a country, and very rare. But that
cost is currently too high.
The introduction of collective action clauses in bond agreements
will help reduce the costs of restructuring when that is necessary. But the
balance between creditors and debtors could also be tilted by changing
the legal framework for standstills and debt restructurings. What would
happen to the international capital markets if the rules could be changed
in this way? The initial reaction is to think that flows would decline, and
spreads would rise. But there is another, more likely, possibility: that
with more room for more orderly resolution of crises, and less risk of
extreme crises, flows would soon rise and spreads would decline as the
stability of emerging market economies grows.
What should we expect? Measures already in place or under way
will increase the stability of the international capital markets, and as
normalcy returns to the global economy, should also lead to greater flows
to countries that are managing themselves well. Work on developing
a better legal framework for standstills and sovereign debt restructuring
should get under way, but will take time to complete and longer to agree.
If the apparent improvements in the ability of the international capital
markets to discriminate among countries continues, thereby helping
provide incentives for g o o d behavior, the system could be operating

far better, with fewer crises, even before a new legal f r a m e w o r k is in
place.
Annex
From the Communiqu~ of the International Monetary and Financial Commit-

tee of the Board of Governors of the International Monetary Fund; September
24, 2000; Press Release No. 00/54
Private Sector Involvement
21. The Committee endorses the report by the Managing Director on the in-
volvement of the private sector in crisis prevention and management. It wel-
comes the progress on developing a framework for involving private creditors
in the resolution of crises. The Committee notes that this approach strikes
a balance between the clarity needed to guide market expectations and the op-
erational flexibility, anchored in clear principles, needed to allow the most ef-
fective response in each case. The Committee notes that Fund resources are
limited and that extraordinary access should be exceptional; further, neither
creditors nor debtors should expect to be protected from adverse outcomes by
official action.
22. The Committee agrees that the operational framework for private sector
involvement must rely as much as possible on market-oriented solutions and
voluntary approaches. The approach adopted by the international community
should be based on the IMF's assessment of a country's underlying payment
capacity and prospects of regaining market access. In some cases, the combi-
nation of catalytic official financing and policy adjustment should allow the
country to regain full market access quickly. The Committee agrees that re-
liance on the catalytic approach at high levels of access presumes substantial
justification, both in terms of its likely effectiveness and of the risks of alter-
native approaches. In other cases, emphasis should be placed on encouraging
voluntary approaches, as needed, to overcome creditor coordination problems.
In yet other cases, the early restoration of full market access on terms consis-
tent with medium-term external sustainability may be judged to be unrealis-
tic, and a broader spectrum of actions by private creditors, including com-
prehensive debt restructuring, may be warranted to provide for an adequately
financed program and a viable medium-term payments profile. This includes
the possibility that, in certain extreme cases, a temporary payments suspen-
sion or standstill may be unavoidable. The Fund should continue to be pre-
pared to provide financial support to a member's adjustment program despite
arrears to private creditors, provided the country is seeking to work coopera-
tively and in good faith with its private creditors and is meeting other program
requirements. The Committee urges progress in the application of the flame-

work agreed in April 2000, and in further work to refine the analytical basis
for the required judgments, and it looks forward to a progress report by its
next meeting.
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Financial Crises and Reform of the

International Financial System

Citigroup, New York

The topic of the reform of the international financial system, or of the

2.1 Country Policies and Institutions

trinity is that an open capital account, a pegged exchange rate, and an

is managed floating plus, where "plus" is shorthand for a framework

where d is the debt-to-GDP ratio, x is the primary surplus (relative to

7 This point is developedin Favero and Giavazzi (2002).

rate shocks than the budget of an industrialized country. Further, the

9 Capital controls are examined by De Gregorio et al. (2000), Eichengreen et al.

15 See Ariyoshi et al. (2000: 18-29) and Edwards (1999: 68-71).

interest rates. In addition, by taxing short-term capital inflows more

account restrictions and how best to remove them. It is striking that

tives should be the desire of policymakers to strengthen the economy

2.2 Actions by the Fund

In addition to self-justifying predictions, it is necessary to consider

the Capital Markets Consultative Group, a group of private sector capital

2.3 Actions by Others

framework for private sector involvement in the resolution of interna-

governs the I M E Given competing demands on the time of officials,

3 Crisis Response and Private Sector Involvement

While it is convenient to draw a distinction between crisis prevention

The IMF's approach to private sector involvement is in a state of

There are recent examples of programs in each category. The Brazil-

does so. Those uncertainties are compounded by the absence of an accepted

What can be done (Eichengreen 2000)? The most important sug-

debt contracts to minimize the impact of the new framework. But we

4 The Operation of the International Capital Markets

As the Mexican crisis developed, and as the Asian crisis intensified, it

specifically, that spreads are so high as to imply a substantial probability

48 This argument is developed at greater length in Fischer (2001b).

provide incentives for g o o d behavior, the system could be operating

From the Communiqu~ of the International Monetary and Financial Commit-

Private Sector Involvement

requirements. The Committee urges progress in the application of the flame-

Ariyoshi, A., K. Habermeier, B. Laurens, I. Oetker-Robe, J. Canales-Kriljenko,

Eichengreen, B., D. Mathieson, B. Chadha, A. Jansen, L. Kodres, and S. Sharma

Williamson, J. (1990). What Washington Means by Policy Reform. In

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