FROM THE OFFICE OF PUBLIC AFFAIRS
April 16, 2004
js-1473
Under Secretary Taylor Remarks to the IMF
Conference in honor of Guillermo Calvo
It is a pleasure for me to be here today to join in honoring Guillermo Calvo. Guillermo has been a close friend for over thirty years. We first met at Columbia University in January 1973. He and I had just arrived as newly minted Ph.D.s, from Yale and from Stanford, respectively, looking forward to doing basic economic research and teaching economics.
We were colleagues at Columbia for the rest of the 1970s before we went our separate ways. I have wonderful memories of those days at Columbia. I recall that we did nothing but economics, all day, every day, but I'm sure that's an exaggeration. We had great colleagues, and we had great students. I am happy to see many of them at this conference.
And it was a great time and place to be doing basic research in the field of macroeconomics. So much was changing as serious dynamic quantitative techniques to model expectations under uncertainty entered the field. Broadly speaking, much of what we did then was work through the economic policy implications of this new “forward looking” or “rational expectations” way of thinking. We were working on new models in which we could systematically examine how people would anticipate policy changes, a big difference from the old “Keynesian” models. This led to such things as: the time inconsistency problem, because expectations of policy had their own predictable effects in the new models; staggered price and wage setting models, because the Phillips curve lost all its traction when rational expectations replaced adaptive expectations; and a focus on “policy regimes” rather than one time changes in the policy instruments, because thinking about future contingency plans became a necessary part of policy analysis.
All that was 30 years ago, and much has changed. Guillermo and I are back in the same town, though it is D.C. not New York, and I have again benefited from conversations over lunch or dinner. And much of macroeconomic policy - especially monetary policy - has changed for the better. The ideas that Guillermo was developing at Columbia at that time - and that he would continue to develop in his remarkable and still very active career - have had a huge impact on this positive change.
Three Recent Policy Reforms at the International Financial Institutions
Today I would like to talk about some very recent policy changes: reforms of the international financial institutions and their policies toward emerging markets and developing countries. The policy changes I will discuss are significant and, in my view, closer to what economists call “policy regime changes” than to one time adjustments in the settings of policy instruments. I will try to offer some personal insights about their implementation, but my main purpose in this talk is to relate these changes to the same expectations issues that Guillermo started working on long ago at Columbia and which continue to be very relevant today.
The three policy reforms that I will highlight are: (1) the use of collective action clauses in sovereign debt; (2) the development of clearer limits and criteria for exceptional borrowing by countries from the official sector; and (3) the greater use of grants rather than loans from the international financial institutions to poor countries. To be sure, there have been other policy changes, including increased transparency which has been part of a global trend at central banks and other financial institutions for a number of years. There has also been a significant streamlining of conditionality in IMF programs and a noticeable increase in the use of measurable results in World Bank projects. But I will focus on these three reforms today, as they closely relate to the expectations issues. All three of these reforms have been proposed, analyzed, and debated for a number of years, but it is only recently that they have actually been implemented.
Changing Market Environments, Financial Crises, and the Need for Policy Reform
An important motivation for these reforms is that international financial markets have undergone fundamental changes in the past decade and a half.
First, securities are a much bigger percentage of cross-border financial flows than in earlier years when bank loans were a larger percentage. This trend began in the late 1980s and is continuing today. An important implication of this change is that restructuring government debt-with literally hundreds of thousands of bond holders in many different countries-became much more difficult and uncertain than when debt had been in the form of bank loans to a few banks or syndicates.
A second change is the increase in the volume of private capital flows. Private debt and equity flows grew to be much larger than official lending from the international financial institutions. Even cross-border transfer payments are now predominantly private with remittances alone much larger than transfers of resources from the international financial institutions and other aid agencies.
A third change is that financial markets are more interconnected than in the past, which is one of the reasons for the concerns about contagion. The cross-border capital flows seemed to be more volatile as well: sudden-stops - to use Guillermo's phrase - and reversals of flows became more frequent.
Other things being equal, I believe that these changes in the cross-border environment led the emerging markets to become more crisis-prone. In fact, both the number and severity of financial market crises increased in the 1990s compared with the 1980s. By the late 1990s, the emerging markets were perceived by investors as so crisis-prone that net private capital flows to emerging markets as a whole fell sharply-a sudden stop for the whole emerging market class.
The initial responses to these crises by the official community in the 1990s were understandable. As in the case of Mexico, the responses had to be developed from scratch in a very short period of time, and they had to be implemented immediately. In a number of cases, and in the Mexican case in particular, some argued that there should have been no special response by the international community, or that the response was wrong. But the point I emphasize is that these crises were providing clearer and clearer evidence that the systemic changes in the world's financial markets required systematic changes in the policy framework underlying the international financial system.
However, the responses of the international community to crises in the 1990s continued in the roughly same fashion as the response to Mexico. They tended to concentrate on tactics rather than strategy. They were designed around discretionary changes in the policy instruments rather than systematic changes in the policy regime. They tended to be government-focused rather than market-focused, emphasizing large loans by the official sector and, later, government-induced bail-ins by the private sector.
Many observers became concerned that the increasing use of very large financial packages and the bail-ins were having adverse effects on expectations or incentives.
A related problem was that loans from the official sector-including from the IMF and the World Bank-to the very poor developing countries in Latin America, Africa, and Asia were building up to clearly unsustainable levels. This led to understandable calls for debt relief. Again the responses, in my view, were more tactical than strategic. They dealt with the current serious need for debt relief, but not with the expectations effects and the incentive problems that would continue to cause the international institutions to lend too much and the poor countries to borrow too much, leading to future debt sustainability problems.
Toward a Policy Regime Change
In sum, something important was missing from the international financial policy framework, namely more predictability, more accountability, and more systematic behavior on the part of the official sector. More focus needed to be placed on what public sector actions were likely to be in a given circumstance, on what accountability there would be for those actions, and on what the strategy and the principles behind the actions were. This is exactly what research on expectations, policy regimes, and time inconsistency - of the kind that Guillermo contributed so much to - would recommend. So let me now explain how these three policy reforms are doing just this.
Collective Action Clauses
The very essence of these clauses is to provide greater predictability. They describe, as a contingency plan, what would happen if a debt restructuring is needed. They state, for example that 75 percent, rather than 100 percent of bondholders have to agree with the restructuring. I emphasize that the aim is not to make restructurings more desirable, but rather to make them more predictable in cases when a country has no real alternative. In the absence of such clauses, fears and uncertainties about what would happen if a country had to begin a restructuring of its debt can interfere with effective decision-making, especially in a charged political environment. An advantage of such clauses is that they are a decentralized, market-based approach with a minimum of direction or discretion by the official sector. In this way too, the clauses reduce the uncertainty that accompanies a non-sustainable debt situation.
Importantly, the clauses also help the official sector to be more credible about both the likelihood and likely size of its own response, and this in turn has favorable effects on market expectations, which can reduce the need for large responses by the official sector. In a recent article in the Journal of Economic Perspectives (Fall, 2003), Barry Eichengreen emphasizes this point and links it to the time inconsistency problem stating, “Reducing the frequency and magnitude of IMF rescue operations requires creating an environment where a commitment by the official community to stand aside is time consistent. One motivation for new approaches to sovereign debt restructurings is thus to open up less costly avenues for debt reorganization, thereby reducing the pressures on the IMF to lend and removing the incentive for investors to engage in additional lending in anticipation of official intervention.”
These clauses have been actively promoted by the United States. After intensive legal and economic research at the U.S. Treasury in late 2001 and early 2002, we concluded that collective action clauses were the most promising and feasible way to introduce more predictability into the system. I then gave a speech in April 2002, calling for implementation of such clauses as fast as possible. Several useful enhancements and additions to the clauses that had been suggested earlier were part of this proposal, but I emphasized principles rather than details recognizing that the borrowing countries and their creditors would have to work out the details. The clauses then became part of the April 2002 G7 Action Plan. That the clauses could help with the time consistency problem was implicit in this Action Plan because they were paired up with the endeavor to clarify and adhere to limits on large scale lending.
I must say I am very pleased with the dramatic progress that has been made in implementing these proposals in a very short period. Mexico included clauses for the first time in its New York law-governed bonds just about a year ago. And now clauses are well on their way to becoming standard in internationally-issued sovereign bonds. A range of countries, including the early clause-issuers Mexico, Brazil, Korea, South Africa and Turkey, have demonstrated that including these clauses in their issues has had no adverse impact on pricing. Just since January, the Philippines, Panama, Colombia, Costa Rica, Indonesia and Israel have all included these clauses for the first time in their New York-issued bonds. Work continues to educate potential issuers about the benefits of these clauses, as we advance this important trend in strengthening market practices. The new clauses are now the market standard in New York.
Some argue that collective action clauses do not solve all the problems about the uncertainty surrounding debt restructurings, and they are right. Aggregation is still a problem, and future crises may not be as closely associated with debt problems as past crises have been. But the clauses and the debate surrounding them last year have helped to change perceptions about emerging market debt. The debt is now being held by a more diverse class of investors as an important part of their portfolios. Moreover, I believe that because the reform was implemented so successfully it has bolstered confidence in the reform process. People see that financial reform is possible even if it is very complex and involves changes in the policies for scores of countries and thousands of lawyers, advisors, investors, and financial institutions. For example, private creditors and borrowing countries now are working on a code of conduct, which could add more predictability and order into the system.
Clarifying Limits and Criteria for Large-Scale Official Sector Lending
There are several components of this reform.
First is the presumption - based on recent practice since the resolution of the Turkey financial crises of 2000-2001 and in particular the assistance package of early 2001 - that the IMF rather than the official creditor governments is responsible for providing large scale loan financing. This provides an overall budget constraint and thereby an overall limit on loan assistance, recognizing that IMF resources are limited.
Second, within the context of this overall limit there has been an endeavor by IMF shareholders and management to signal in advance of a decision not to provide additional IMF loans when it appears that the limits of sustainability may be reached in the near future. Signaling policy changes in advance - even in broad outline form - can lead to smoother adjustments and provide investors with time to obtain information about fundamentals. This reduces greatly the chances of contagion, because surprise increases or decreases in official financing can lead to runs for the exits and sudden stops. Also part of the principal of limiting funding when countries continue to follow unsustainable policies is to assist countries that are following good policies but may be hit by a crisis in the nearby country that is not following good policies. This too will help to reduce contagion in the event that the near-crisis country does in fact go into financial crisis. The clearest example of this is the case of Argentina where additional IMF resources were not suddenly stopped in 2001, but rather continued with signals - including restructuring funds built into the August 2001 program - that additional funding in the face of the ongoing debt sustainability problem would not continue. In addition a financial assistance package was provided to Uruguay - which had been following good policies - to deal with the monetary crisis brought on by the bank runs of its close neighbor around the time of the default in December 2002.
The third component of this reform adds specificity and accountability to the first two components. This is the agreement by the IMF Board in March 2003 on four specific criteria that should be met before large scale lending above certain limits can take place. The criteria are: (1) balance of payments pressures on capital account, (2) high probability of debt sustainability, (3) good prospects of regaining access to private markets so that IMF financing provides a bridge, and (4) good economic policies in place. In addition the IMF Board adopted the requirement that, in cases of exceptional access, a new exceptional access report has to be prepared and published by the IMF management. The aim of the exceptional access report is to provide accountability in the same way that monetary policy reports or inflation reports provide some accountability at central banks.
Because these criteria must be interpreted in each case, it is clear that the limits themselves are not rigid. The reality of the market and policy environment is that the IMF management and the IMF member governments should use the criteria judiciously rather than rigidly. One cannot plan for all contingencies and so the criteria are closer to policy principles or guidelines. Nevertheless, the specific criteria represent a marked change in the direction of a more systematic and predictable policy regime.
The purpose of limits is to reduce the uncertainty and the perverse disincentives in the markets due to lack of clarity about how much funding will be provided from the IMF and under what circumstances. The clearer limits help define the policy regime under which market participants and borrowing countries can operate. As part of the policy framework defined by the clearer access limits, the general presumption is that the official sector will avoid arm-twisting the private sector to do bail-ins, because this can lead to uncertainty about future applications and encourage early runs for the exits.
With these criteria in place, the question is frequently asked about how they were applied last year in the cases of Argentina and Brazil. In both of these cases, however, the countries were already in exceptional access territory and the goal is to exit from this exceptional access over time. The Argentina program is now focused on a complex debt restructuring. And a goal of the Brazil program is to exit from the exceptional access.
Grants Rather Than Loans to Very Poor Countries
Providing more grants to poor heavily indebted countries is necessary to deal with their long run debt sustainability problems. Debt forgiveness through the HIPC process in a way that deals with their debts to the international financial institutions is essential for the countries with unsustainable debt situations. But if the international financial institutions return to their heavy emphasis on lending, then there are perverse incentives for these countries to get into an unsustainable situation again, which will lead to the debt relief cycle all over again.
This is more than a simple financial issue. Unsustainable government debt not only requires large budget resources, it reduces private sector investment needed for economic growth and poverty reduction. Using grants rather than loans, therefore, avoids leading these countries down the path of heavy indebtedness.
Of course, this is a fundamental and difficult reform. Since their founding 60 years ago, the managements and shareholders of the Bretton Woods Institutions have thought of them primarily as lending institutions. Nevertheless, remarkably good progress has been made in implementing this reform. In 2002 an international agreement was reached to use up to 21 percent of the World Banks' IDA window for grants. This agreement allows substantially larger percentages in the heavily indebted IDA countries.
The grants have proved very popular in the countries that have received them thus far, but work needs to be done to further increase grant funding for the very poorest and heavily indebted countries and to integrate this more systematically into the debt relief process.
Market Developments Around the Policy Changes
Let me conclude by looking at recent developments in emerging markets that have accompanied these reform changes. I am happy to say that there has been a big improvement in performance. For one thing, the number of major financial market crises is fortunately way down. I am sure that the policy changes have not been a force against improved performance, and I have argued here that improved performance is consistent with the policy changes. But economics being the inexact science that it is, complete empirical proof of the benefits of the reforms is a ways off.
I offer three of my favorite figures to illustrate different aspects of the improved performance.
High Points and Saddle Points in the Policy Reform Process
Of the many conversations I had with Guillermo, I would like to conclude with one that I remember well. I was telling him about a back packing trip I had just made to the Sawtooth Mountains of Idaho. I was describing the rugged terrain and a particularly tough climb up to what appeared in the mountain mist to be a high point, but when I got there I saw that it was a saddle point and I had to turn right or left and continue the tough climb. We joked that life was like “one saddle point after another.”
I think the same can be said of the policy reform process. In this talk I have tried to explain how a recent series of policy reforms at the international financial institutions can be interpreted as a high point, as a policy regime change of the kind recommended by the work on expectations in macroeconomics-from time inconsistency to sudden stops-which Guillermo Calvo has contributed so much too. Because of his influential work over the years, we are all in better shape to keep making progress as we move on from one policy reform saddle point to another.
Thank you.
REPORTS