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The international financial system is suffering a systemic
breakdown, but
we are unwilling to acknowledge it. The abandonment of
fixed exchange rate
regimes in south-east Asia touched off an unraveling
process that has
exceeded everyone's worst fears, including my own. So
far the large
bail-out programs implemented by the International Monetary
Fund have not
worked.
Lending by the international financial institutions can
never replace
lending by the private sector. The rescue packages are
supposed to do
their work by re-establishing private sector confidence.
Unfortunately,
the currencies of the debtor countries have continued
to depreciate,
aggravating their debt problems and further undermining
confidence.
The countries concerned were over-indebted to start with.
The decline in
their currencies, coupled with the drastic rise in interest
rates, has
rendered the debt burden even more crushing.
We are dealing with a self-reinforcing process. Once it
is reversed, it
could become self-reinforcing in the opposite direction.
The trouble is
that the process is still moving away from equilibrium.
It is impossible
to tell how far it may go. What started out as a minor
imbalance has
become a much bigger one that threatens to engulf not
only international
credit but also international trade. We are on the verge
of worldwide
deflation.
The IMF has been criticized for applying the wrong remedy.
The FT's
columnist Martin Wolf has pointed out that the deflationary
effect of the
debt burden is reinforced by the deflationary effect
of the IMF programs.
Jeffrey Sachs, director of the Harvard Institute for International
Development, has carried the criticism further by blaming
the IMF for
insisting on punitively high interest rates. But high
interest rates are
essential to prevent the currency from going into a free
fall. They have
served to protect the exchange rate in countries as diverse
as Hong Kong
and Russia. It is difficult to see how high interest
rates could be
avoided, given the constraints under which the IMF operates.
The problems run much deeper. But we are unwilling to
face them. The
prevailing system of international lending is fundamentally
flawed yet the
IMF regards it as its mission to preserve the system.
This does not imply
I am not a great believer in the IMF. Without it, and
without other
official creditors, the system would already have collapsed
in 1982 and
again in 1994-95. With luck, we may pull through once
again. But it is
high time to recognize the defects of the system and
reconsider the
mission of the fund.
The private sector is ill-suited to allocate international
credit. It
provides either too little or too much. It does not have
the information
with which to form a balanced judgment. Moreover, it
is not concerned with
maintaining macro-economic balance in the borrowing countries.
Its goals
are to maximize profit and minimize risk. This makes
it move in a
herd-like fashion in both directions.
The excess always begins with overexpansion, and the correction
is always
associated with pain. But with the intervention of the
IMF and other
official lenders, the pain is felt more by the borrowers
than by the
creditors. That is why overexpansion has recurred so
soon after each
crisis. Successive crises have, however, become more
difficult to handle.
In 1982, banks lending to Latin America were involved
for their own
account. The crisis was contained by persuading them
to act collectively
and to extend fresh credit to allow the debtors to service
their debt. The
banks did get hurt in the process although not as much
as the borrowers.
Latin America lost a decade of growth. The banks learned
to minimize their
own exposure and to act as underwriters and wholesalers
instead.
In the 1994-95 crisis, it was the holders of Mexican treasury
bills that
had to be bailed out, mainly by the US Treasury. By 1997
some of the banks
had forgotten their painful experiences and became engaged
on their own
account, particularly with South Korean companies.
The Korean crisis, as distinct from that in other south-east
Asian
countries, bears some similarities to Brazil in 1982
- with one major
difference: the loans are not to Korea as a sovereign
country but to
individual companies. This has made it more difficult
to get the banks to
act collectively.
Since we are in the middle of a crisis it is impossible
to predict how it
will play itself out. There are other shoes that may
yet drop, notably
China. On the other hand, Japan, which looks so bad at
present, has the
wherewithal to solve its problems.
It is not too soon to start thinking how the system could
be improved.
Fresh ideas on the subject could even have a beneficial
effect on how the
current crisis is handled. But that would require questioning
some of the
most cherished tenets of the business community. To argue
that financial
markets in general, and international lending in particular,
need to be
regulated is likely to outrage the financial community.
Yet the evidence
for just that is overwhelming.
Given the uneven distribution of savings and investment
opportunities,
there is a crying need for international capital movements.
But the
private sector is notoriously inefficient in the international
allocation
of credit. It follows that international capital movements
need to be
supervised and the allocation of credit regulated by
an international
authority.
This goes against the grain of prevailing wisdom. How
can bureaucrats know
better than those who take risks for their own account?
The answer is that
the technocrats running the proposed international authority
would be
charged with maintaining macroeconomic balance, while
the technocrats in
charge of banks are guided by profit considerations.
Banks earn fees as
well as a return on capital and in the end they can count
on the support
of the official lenders, because IMF and central bank
intervention - like
that in Korea - tends to favor creditors. It would be
better for the
official lenders to control the risks they are taking
more directly.
I propose setting up an International Credit Insurance
Corporation as a
sister institution to the IMF. This new authority would
guarantee
international loans for a modest fee. The borrowing countries
would be
obliged to provide data on all borrowings, public or
private, insured or
not. This would enable the authority to set a ceiling
on the amounts it is
willing to insure. Up to those amounts the countries
concerned would be
able to access international capital markets at prime
rates. Beyond these,
the creditors would have to beware.
The authority would base its judgment not only on the
amount of credit
outstanding, but also on the macroeconomic conditions
in the countries
concerned. This would render any excessive credit expansion
unlikely. The
capital of the proposed institution would consist of
Special Drawing
Rights. This would render its guarantees watertight.
The SDRs would not
be inflationary because they would be used only in case
of default; at
that time they would replace money that had been lost.
There are many issues to be resolved. The most important
is the link
between the borrowing countries and the borrowers within
those countries.
Special care must be taken not to give governments discretionary
power
over the allocation of credit because that could foster
corrupt
dictatorships. But once the need for such an institution
is recognized,
the details could be worked out.
The institution can be set up only at a time when international
lending is
in a state of collapse. We are now entering such a period.
We can probably
navigate through it without setting up a new international
authority of
the sort I am proposing. But we would be missing a great
opportunity.
Moreover, the extent of the crisis could be mitigated
by the prospect of
an early revival of international lending on a sounder
footing. If the
world is indeed entering a deflationary period, an International
Credit
Insurance Corporation could play an important role in
containing its
negative effects.
The author is chairman of Soros Fund Management and of
the Open Society
Institute.
