Select Committee on Treasury Written Evidence


Memorandum submitted by Professor Ilene Grabel, University of Denver

A PROACTIVE ROLE FOR THE IMF: TRIP WIRES AND SPEED BUMPS IN SERVICE OF GLOBAL FINANCIAL STABILITY

Executive summary

  Since the 1990s, financial crises in developing countries have become both more frequent and more severe. The interconnected nature of financial markets means that financial crises easily spread across national borders. By now, there is incontrovertible evidence that financial crises impose significant economic, political and social costs. Financial crises in developing countries also have powerful effects on financially stable economies, such as the UK. Moreover, the UK shoulders some of the cost of resolving financial crises through the controversial bailouts that are financed by member country contributions to the IMF. Thus, taxpayers in the UK ultimately bear the burden of providing financial support for the Fund's role in responding to crises.

  It is in the UK and the global interest to encourage the IMF to become a pro-active rather than a reactive institution. Toward this end, I argue that the IMF should use its technical expertise and the financial contributions of its members to mitigate the financial risks that so often culminate in financial crises in developing countries. This new role would involve a program of "trip wires and speed bumps." Trip wires and speed bumps are straightforward, transparent policy tools that can be used to identify and mitigate financial risks as soon as they become apparent to the IMF and to national policy makers.

  Trip wires are a type of diagnostic tool. Specifically, trip wires are indicators of vulnerability that can illuminate the specific risks to which developing economies are exposed. Among the most significant of these vulnerabilities are the risk of large-scale currency depreciations, the risk that domestic and foreign investors and lenders may suddenly withdraw capital, and the risk that the depreciation of the local currency or an increase in the cost of new foreign loans will make it more difficult for a developing country to repay its existing obligations to international lenders. Speed bumps are narrowly targeted, gradual changes in policies and regulations that are activated whenever trip wires reveal particular vulnerabilities in the economy. It would be the task of policymakers within their own countries to work with the technical staff of the IMF to establish appropriate thresholds for each trip wire, taking into account the country's particular characteristics (eg, size, level of financial development, regulatory capacity) and its unique vulnerabilities (eg, existing conditions in the domestic banking system, stock market, corporate sector, etc.). The trip wire-speed bump approach calls upon the IMF to recommend that national regulators activate gradual speed bumps at the first signs of vulnerability.

  The time is ripe to reconceptualise the role of the IMF. The trip wire-speed bump program described here represents a promising means by which the IMF can reduce the specific financial risks that so often culminate in costly and painful financial crises in developing countries. The chief advantages of this approach are that it can target only those risks that IMF staff and national policymakers deem most important, it can be implemented gradually, it is transparent, and it provides a way for the IMF and developing country policymakers to promote both global financial integration and global financial stability.

Introduction

  1.  Since the 1990s, financial crises in developing countries have become both more frequent and more severe. The interconnected nature of financial markets (also known as "financial globalisation") means that financial crises easily spread across national borders. A partial list of the financial crises that have occurred since the mid-1990s includes Mexico, Thailand, South Korea, Indonesia, Malaysia, the Philippines, Russia, Brazil, Argentina and Turkey.

  2.  By now, there is incontrovertible evidence that financial crises impose significant economic, political and social costs. For instance, there is a large body of evidence that shows that financial crises cause sharp downturns in overall economic activity and investment, and increase levels of unemployment, poverty and income inequality. In addition, evidence shows that financial crises are associated with political instability as regime shifts and social turmoil often follow financial crises. In this manner, financial crises in developing countries have powerful effects on financially stable economies, such as the UK. The UK also shoulders some of the cost of resolving financial crises through the controversial bailouts that are financed by member country contributions to the IMF. Thus, taxpayers in the UK ultimately bear the burden of providing financial support for the Fund's role in responding to crises.

  3.  This memorandum makes the case that it is in the UK and the global interest to encourage the IMF to become a pro-active rather than a reactive institution. Toward this end, I argue that the IMF should use its technical expertise and the financial contributions of its members to mitigate the financial risks that so often culminate in financial crises in developing countries. This new role would involve a program of what I term "trip wires and speed bumps." Trip wires and speed bumps are straightforward, transparent policy tools that can be used to identify and mitigate financial risks as soon as they become apparent to the IMF and to national policy makers. In what follows, I describe the workings of a trip wire-speed bump program in some detail (for further details, please contact the author, or see Grabel, 2004, G-24 Discussion Paper No 33, www.g24.org.005gva04.pdf]. [53]

  4.  What are trip wires? Trip wires are a type of diagnostic tool. Specifically, trip wires are indicators of vulnerability that can illuminate the specific risks to which developing economies are exposed. Among the most significant of these vulnerabilities are the risk of large-scale currency depreciations, the risk that domestic and foreign investors and lenders may suddenly withdraw capital, and the risk that the depreciation of the local currency or an increase in the cost of new foreign loans will make it more difficult for a developing country to repay its existing obligations to international lenders.

  4.1  In what follows, I suggest trip wires that focus on the particular financial risks identified above.

  4.1.1  Currency risk refers to the possibility that a country's currency may experience a sudden, significant depreciation. Currency risk can be evidenced by the ratio of official reserves held by the government to total short-term external obligations (the sum of accumulated foreign portfolio investment and short-term hard-currency denominated foreign borrowing); and the ratio of official reserves to the current account deficit.

  4.1.2  Fragility risk refers to the vulnerability of an economy's private and public borrowers to internal or external shocks that jeopardize their ability to meet current obligations. Fragility risk arises in a number of ways. Borrowers finance long-term obligations with short-term credit, causing what is termed maturity mismatch. This leaves borrowers vulnerable to changes in the supply of credit, and thereby exacerbates the ambient risk level in the economy. A proxy for maturity mismatch could be given by the ratio of short-term debt to long-term debt (with foreign-currency denominated obligations receiving a greater weight in the calculation).

  4.1.3  Fragility risk also arises when borrowers contract debts that are repayable in foreign currency, causing what is termed locational mismatch. This leaves borrowers vulnerable to currency depreciation that may frustrate debt repayment. Locational mismatch that induces fragility risk could be evidenced by the ratio of foreign-currency denominated debt (with short-term obligations receiving a greater weight in the calculation) to domestic-currency denominated debt. In general, we might think of the dangerous interactions between currency and debt market conditions as introducing the possibility of inter-sectoral contagion risk.

  4.1.4  Lender flight risk refers to the possibility that private, bi-, or multi-lateral lenders will call loans or cease making new loans in the face of perceived difficulty. An indicator of lender flight risk is the ratio of official reserves to private and bi-/multi-lateral foreign-currency denominated debt (with short-term obligations receiving a greater weight in the calculation).

  4.1.5  Portfolio investment flight risk refers to the possibility that portfolio investors (that is, investors in a country's stock and bond markets) will sell off the assets in their portfolio, causing a reduction in asset prices and increasing the cost of raising new sources of finance. Vulnerability to the flight of portfolio investment can be measured by the ratio of total accumulated foreign portfolio investment to gross equity market capitalization or gross domestic capital formation. Lender and portfolio investment flight risk often creates a self-fulfilling prophecy that deflates asset and loan collateral values, induces bank distress and elevates ambient economic risk. In addition, lender and/or portfolio investment flight risk can interact with currency risk to render the economy vulnerable to financial crisis (causing inter-sectoral contagion).

  5.  What are speed bumps? Speed bumps are narrowly targeted, gradual changes in policies and regulations that are activated whenever trip wires reveal particular vulnerabilities in the economy. It would be the task of policymakers within their own countries to work with the technical staff of the IMF to establish appropriate thresholds for each trip wire, taking into account the country's particular characteristics (eg, size, level of financial development, regulatory capacity) and its unique vulnerabilities (eg, existing conditions in the domestic banking system, stock market, corporate sector, etc.). Critical values for trip wires and the calibration of speed bumps would be revised over time in light of experience, changes in the economy, and improvements in institutional and regulatory capacity.

  5.1  Sensitive trip wires would allow policymakers to activate graduated speed bumps at the earliest sign of heightened risk, well before conditions for investor panic had materialized. When a trip wire indicates that a country is approaching trouble in some particular domain (such as new short-term external debt to GDP has increased over a short period of time), policymakers could then immediately take steps to prevent crisis by activating speed bumps. Speed bumps would target the type of risk that is developing with a graduated series of mitigation measures that compel changes in financing and investment strategies and/or dampen market liquidity.

  5.2  Trip wires could indicate to policymakers and investors whether a country approached high levels of currency risk or particular types of fragility or flight risk. The speed bump mechanism provides policymakers with a means to manage measurable risks, and in doing so, reduces the possibility that these risks will culminate in a national financial crisis. Speed bumps affect investor behavior directly (eg, by forcing them to unwind risky positions, by providing them with incentives to adopt prudent financing strategies, etc.) and indirectly (by reducing their anxiety about the future). Together, their effects mitigate the likelihood of crisis. Those countries that have trip wires and speed bumps in place would also be less vulnerable to cross-country contagion because they would face lower levels of risk themselves.

  5.3  Note that there is precedent for the trip wire-speed bump approach in the stock markets and futures exchanges in both the UK and the USA. Within these markets, automatic circuit breakers and price limits are used to dampen market volatility and stabilize extreme market swings. Regulatory authorities also have discretionary authority to stop trading or temporarily close an exchange or the trading in one particular security or derivative.

  5.4  Speed bumps can take many forms. A range of possible speed bumps that correspond to the specific financial risks illuminated by trip wires is presented below.

  5.4.1  Currency risk can be managed through activation of speed bumps that limit the fluctuation of the domestic currency value or that restrict currency convertibility in a variety of ways. Historical and contemporary experience demonstrates that there are a variety of means by which currency convertibility can be managed. For instance, the government can manage convertibility by requiring that those seeking access to the currency apply for a foreign exchange license. This method allows authorities to influence the pace of currency exchanges and distinguish among transactions based on the degree of currency and financial risk associated with the transaction. The government can suspend or ease foreign exchange licensing as a type of speed bump whenever trip wires indicate the early emergence of currency risk. The government can also activate a policy of selective currency convertibility, if trip wires illuminated the emergence of currency risk. Specifically, a speed bump might allow the currency to be convertible for current account transactions only. It is important note that the IMF's Articles of Agreement (specifically, Article 8) provide for this type of selective convertibility.

  5.4.2  Policymakers would monitor a trip wire that measures the economy's vulnerability to the cessation of foreign lending. If the trip wire approached an announced threshold, policymakers could then activate a graduated speed bump that precluded new inflows of foreign loans until circumstances improved. Alternatively, a speed bump might rely upon the tax system to discourage domestic borrowers from incurring new foreign debt obligations whenever trip wires indicated that it would be desirable to slow the pace of new foreign borrowing. In this scenario, domestic borrowers might pay a fee to the government or the central bank equal to a certain percentage of any foreign loan undertaken. This surcharge might vary based on the structure of the loan, such that loans that involve a locational or maturity mismatch incur a higher surcharge. Surcharges might also vary based on the level of indebtedness of the particular borrower involved, such that borrowers who already hold large foreign debt obligations face higher surcharges than do less-indebted borrowers. This tax-based approach would encourage borrowers to use (untaxed) domestic sources of finance. Surcharges might also vary according to the type of activity that was being financed by foreign loans. For instance, borrowers might be eligible for a partial rebate on foreign loan surcharges when loans are used to finance export-oriented production.

  5.4.3  If a trip wire revealed that a country was particularly vulnerable to the reversal of portfolio investment inflows, a graduated series of speed bumps would slow the entrance of new inflows until the ratio falls either because domestic capital formation or gross stock market capitalization increased sufficiently or because foreign portfolio investment falls. Thus, a speed bump on portfolio investment would slow unsustainable financing patterns until a larger proportion of any increase in investment could be financed domestically. I emphasise the importance of speed bumps governing inflows of portfolio investment because they exert their effects at times when the economy is attractive to foreign investors, and so are not as likely as outflow restrictions to trigger investor panic. Though not a substitute for outflow controls, inflow restrictions also reduce the frequency with which outflow controls must be used, and their magnitude.

  5.4.4  The fragility risk that stems from excessive reliance on inflows of international portfolio investment or foreign loans could be curtailed by the speed bumps that focus on these types of flight risks (see above). The fragility risk from locational and/or maturity mismatch could be mitigated by a graduated series of speed bumps that requires borrowers to reduce their extent of locational or maturity mismatch by unwinding these activities, or by imposing surcharges or ceilings on them whenever trip wires revealed the early emergence of these vulnerabilities.

  5.5  There are several guidelines that might guide the design of speed bumps in particular countries.

  5.5.1  Speed bumps that govern inflows are preferable to those that govern outflows because measures that target outflows are more apt to trigger and exacerbate panic than to prevent it. This does not mean that outflow controls are not useful during times of heightened vulnerability, especially if the government uses the "breathing room" garnered by temporary outflow controls to make changes in economic policy or to provide time for an investor panic to subside. Indeed, Malaysia's successful use of temporary controls on outflows in 1994 and again in 1998 shows that temporary outflow controls can protect the economy from cross-border contagion risk in a time of heightened financial risks.

  5.5.2  Graduated, modest, and transparent speed bumps can address a financial risk before it is too late for regulators to take action. Such speed bumps are also less likely to cause an investor panic.

  5.5.3  Finally, should speed bumps be automatic (ie, rule based) or subject to policymaker discretion? Automatic speed bumps have the advantage of transparency and certainty, attributes that may be particularly important to investors. They also have lower administrative costs. But discretionary speed bumps have advantages, too. They provide regulators with the opportunity to respond to subtle and unique changes in the international and domestic environment. However, discretionary speed bumps have higher administrative costs and require a greater level of policymaking capacity. The most prudent answer to the question of discretion is that there is no single, ideal framework for speed bumps in all developing countries. In general, the best that can be said is that speed bumps should be largely automatic and transparent in their operation, though this does not mean that regulators could or even should be expected to eliminate all discretion in the activation of speed bumps. It is the task of the IMF and national policymakers to determine the appropriate balance between automatic and discretionary speed bumps, particularly in light of their assessment of immediate technical capacities.

  6.  I anticipate and respond to a number of concerns that could conceivably be raised by skeptics of this approach.

  6.1  Concern 1: A trip wire-speed bump program cannot reduce the unpredictability and volatility of cross-border and/or cross-currency capital flows. Therefore the utility of this approach is questionable.

  6.1.1  This approach to policy responds precisely to the volatility and lack of predictability of cross-border capital and currency flows in largely unregulated global financial markets. Rather than trying to do a better job of predicting what cannot be predicted (ie, financial flows in unregulated global financial markets), this approach manages and "domesticates" otherwise unruly flows.

  6.2  Concern 2: The activation of trip wires and speed bumps might ironically trigger the very instability that they are designed to prevent.

  6.2.1  This concern does not take account of the possibility that if an economy is less financially fragile by virtue of a trip wire-speed bump program, then investors and lenders will not be so likely to rush to the exits at the first sign of difficulty. Moreover, an economy in which financial risks are curtailed (by trip wires and speed bumps) will be more resilient in the face of investor/lender flight risk.

  6.3  Concern 3: The trip wire-speed bump proposal is unnecessary because private investors and credit rating agencies can do a better job of identifying financial vulnerabilities than can governments.

  6.3.1  There is no reason to expect that private investors will identify financial risks as they emerge, and engage in behaviors that curtail these risks. Moreover, the panicked responses of private foreign and domestic investors to identified risks can actually aggravate—rather than ameliorate—financial instability. Indeed, we saw precisely this dynamic unfold in all of the recent financial crises in developing countries.

  6.3.2  The experience of the East Asian crisis of 1997-98 provides no basis to expect that trip wires and speed bumps are unnecessary since private credit rating agencies provide useful diagnostics on emerging financial vulnerabilities. Indeed, evidence shows that assessments by private credit rating agencies failed to highlight emerging problems in Argentina, Turkey, East Asia and Turkey.

  6.4  Concern 4: Trip wires and speed bumps will not achieve their objectives because economic actors will evade them.

  6.4.1  Policy evasion (in any domain of policy) cannot be ignored. In the case of trip wires and speed bumps, financial innovation may provide a means for some economic agents to evade these polices. However, the middle-income countries that have the most to gain by trip wires and speed bumps are also in the best position to enforce them. It is also important to acknowledge that a degree of policy evasion does not imply policy failure. It is imperative that the particular speed bumps adopted be consistent with national conditions, including state/regulator capacity.

  6.5  Concern 5: Many developing countries do not have the technical policy-making capacity that is necessary for the success of trip wires and speed bumps.

  6.5.1  It is certainly true that policy-making capacity differs dramatically across developing countries. Those developing countries (generally speaking, middle-income countries) that have the highest levels of policy-making capacity are certainly in the best position to utilize trip wires and speed bumps. This is, in some sense, a happy coincidence because policymakers in these same countries have the most to gain by curtailing many of the financial risks that are targeted by trip wires and speed bumps.

  6.5.2  It also bears mentioning that the technical prerequisites for operating trip wires and speed bumps are no greater than those that are demanded of policymakers that operate in an environment of liberalised, internationally integrated financial markets. Moreover, technical capacity can be acquired, particularly were the IMF's role reconceptualized so that institution offered the technical support and the training necessary to make a trip wire-speed bump program viable in the developing world.

  6.6  Concern 7: Countries that implement trip wires and speed bumps will face increased capital costs and lower rates of economic growth.

  6.6.1  There is no unambiguous empirical evidence of a tradeoff between speed bumps and increased capital costs or reduced economic growth. This may be because although foreign investors value the liquidity associated with unregulated financial markets, they may come to favor economies that give them less reason to fear financial crisis (since during sudden crises liquidity is jeopardized). For this reason, developing economies as a whole might find it substantially easier and less costly to attract private capital flows if they reduced their vulnerability to crisis through collective implementation of trip wire-speed bump policies. Moreover, given the losses sustained by investment funds in the UK following financial crises in developing countries, there is good reason to expect that fund managers are placing an increasing value on financial stability in the developing world. Taxpayers in the UK, too, have reason to value financial stability in the developing world, particularly in light of recent concerns about taxpayer support for IMF bailouts.

  6.7  Upon examination, I find arguments against the feasibility and utility of a trip wire-speed bump approach unconvincing.

  7.  The time is ripe to reconceptualise the role of the IMF from a reactive to a proactive institution. The trip wire and speed bump program described here represents a promising means by which the IMF can serve to reduce the specific types of financial risks that so often culminate in costly and painful financial crises in developing countries. The chief advantages of this approach are that it can target only those risks that IMF staff and national policymakers deem most important, it can be implemented gradually, it is transparent, and it provides a way for the IMF and developing country policymakers to promote both global financial integration and global financial stability.

Director of the Graduate Program in Global Finance, Trade and Economic Integration

Graduate School of International Studies

January 2006







53   I. Grabel, "Trip Wires and Speed Bumps: Managing Financial Risks and Reducing the Potential for Financial Crises in Developing Economies," prepared for the XVIIIth Technical Group Meeting of the G-24 in Geneva, Switzerland, 8-9 March 2004. Published as G-24 Discussion Paper No 33, November 2004, United Nations and Geneva. Back


 
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