CHAPTER 7: THE INTERNATIONAL FINANCIAL
234. Globalisation has a macroeconomic and a financial
dimension. A number of witnesses have linked national economic
crises in many less developed countries to faults in the current
international financial system and to the way it is administered
by international economic institutions. The system is said to
benefit developed countries at the expense of less developed countries.
International economic institutions are accused of not doing enough
to create a fairer financial system and of creating excessive
capital mobility and exchange rate volatility thereby de-stabilising
Development of the global
235. The globalisation of capital markets is not
a new phenomenon: "The figures tell a clear story about capital
markets: they were highly integrated in the late nineteenth century,
disintegrated during the inter-war period, and are only now recovering
the levels of integration experienced in 1913."
236. Following the Second World War, the Bretton
Woods settlement saw the establishment of international institutions
which sought to "re-create the international economy that
had brought prosperity before the First World War while safeguarding
against the dislocation of the 1930s that had led to the Second".
The post-Second World War international financial architecture
was designed largely to promote the benefits of trade. Andrew
Crockett, in his written evidence, observed that the post-war
economic order was an attempt to avoid the "
experience with isolationism and the monetary disorder of the
" (Ev I, p 155). The Bretton Woods
system aimed to promote free trade through a set of mutually agreed
"rules of the game". It embraced capital controls because
it was thought this would "
make it easier to pursue
the twin objective of full employment
and balance payments of equilibrium". In Andrew Crockett's
view, trade liberalisation made it harder to maintain capital
account restrictions with the result that "
liberalised capital flows as a means of 'leveraging' the benefits
accruing from the trade side." (Ev I, p 156).
237. The Bretton Woods system was based on the US
dollar. All exchange rates were pegged to it. As Professor Ronald
McKinnon, Senior Fellow of the Stanford Institute of Economic
Policy, explained in his evidence, much of the world's trade was
invoiced in US dollars. The US provided the risk-free assets in
the system and had an almost unlimited credit line with the rest
of the world (Ev I, Q 528). Even today, the US dollar acts as
the world's vehicle currency for trade, and the US must have a
trade surplus in order to supply the world with currency and credit.
The dominance of the US dollar - what Professor McKinnon describes
as the "currency asymmetry" - was therefore built into
the system from its inception, and it continues today.
238. In the early 1970s, the Bretton Woods system
of fixed exchange rates broke down, flexible exchange rates re-emerged
and capital market integration resumed. The reasons for the breakdown
are still controversial. It is widely thought that a major factor
was high domestic US inflation in the late 1960s, rather than
the removal of capital controls. The rise in the real price of
oil, accompanied by many governments' faulty response to it, also
had an effect. High US inflation caused a loss of US competitiveness
and so undermined the US trade balance and the value of dollar-denominated
financial assets. Countries therefore sought a realignment of
exchange rates. The easiest way for this to happen was for the
US dollar to devalue against gold. This precipitated the general
floating of exchange rates as countries searched for the most
appropriate exchange rate level. Under Bretton Woods, monetary
policy for all countries was, in effect, determined by the US
due to the need to maintain the exchange rate parity with the
dollar. Having a flexible exchange rate meant that a country could
now determine its own monetary policy and compete for financial
capital in world markets. It became increasingly apparent in the
years immediately following that capital controls were no longer
needed or desirable for most developed countries.
239. Although the broad level of capital market integration
is not new, the composition of the capital flows differs markedly
from that in pre-First World War globalisation. Andrew Crockett
described the difference as follows: "In the more recent
[phase of globalisation], short-term, notably bank flows are larger;
foreign direct investment has become more important relative to
portfolio flows; and within portfolio flows, the share of equity
is higher." (Ev I, p 155). The character of current capital
flows has been determined in part by advances in technology which
has allowed the more efficient trading of traditional financial
instruments and the development of more complex financial products.
It has also been affected by changes in the organisation of production
of transnational corporations, with increased fragmentation of
the production process leading to increased FDI. Whilst the increase
in FDI has given rise to some concerns (see Chapter 5), the evidence
we received suggests that the greater concern is short-term speculative
capital flows and the consequent financial and exchange rate instability.
The effects of capital
Benefits of the removal of capital controls
240. The removal of capital controls resulted in
more integrated world capital markets. This has tended to create
cheaper and more plentiful international credit, thereby promoting
economic development and trade. For example, Stephen King, Managing
Director, Economics, HSBC, told us: "From a resource allocation
perspective, if capital can flow to immobile - but potentially
productive - labour, there should be benefits in terms of rising
and greater social cohesion." (Ev I, p 70).
George Soros argued that capital mobility was at the heart of
globalisation. He suggested that globalisation of the financial
markets had brought "great benefits": "
in helping to generate aggregate wealth and also in offering a
degree of freedom that cannot be offered by any individual state."
(Ev II, Q 1925). Not only did the evidence we receive suggest
that capital market liberalisation has benefited developed countries
but we also heard evidence that it had benefited some emerging
developing economies as well. Tito Mboweni of the South Africa
Reserve Bank told the Committee that the removal of capital controls
had led to a massive participation by non-residents in their financial
markets, which had quite clearly been a positive feature of the
opening up of the economy after apartheid. Martin Wolf suggested
that without reforms to exchange control liberalisation a number
of developing countries would have grown more slowly than they
did, particularly India and China (Ev II, Q 1588).
241. Capital market liberalisation may also help
spread the financial risks that arise from increased trade specialisation.
As Willem Buiter put it: "Access to global financial markets
and international portfolio diversification makes it possible,
in principle, to insure the residents of a nation against the
risks (eg terms of trade shocks) associated with specialising
in the production of a relatively narrow bundle of goods and services
in an uncertain global environment." (Ev I, p 85).
242. There are also distinct disadvantages to having
capital controls. By restricting outflows, they tend to reduce
the domestic rate of return (because domestic residents having
restricted, or no, access to higher returns in international markets
are confined to lending at lower rates domestically). This may
discourage savings and lead to thin domestic capital markets,
although governments and other borrowers will be able to borrow
more cheaply. Capital controls also discourage inflows, because
investors fear that they will not be able to withdraw earnings.
This discouragement of inwards investment constrains economic
243. Furthermore, fears about the transitional effects
of the removal of capital controls appear, to some extent, to
be misplaced. Often when capital controls are removed, instead
of capital fleeing, it flows in to take advantage of unexploited
investment opportunities and this promotes economic growth and
development. Indeed, even those witnesses who argued in favour
of capital controls in some cases did not argue against their
eventual removal. For example, Professor McKinnon noted that western
Europe kept capital controls for a long time after the war, but
"once a country fully industrialises and gets good internal
financial markets, then it can ease the capital controls".
He also pointed out that not everybody could have capital controls:
"The post-war system could not have worked if the US also
had capital controls, but given it is the central money, it is
better to have capital controls in the peripheral countries. This
is true for the emerging market economies (Asia, Latin America
and much of Africa) at the present time." (Ev I, Q 547).
Gerald Holtham, Chief Investment Officer, Morley Fund Management,
thought that capital controls were a legitimate short-term instrument
but argued that there should be "
a sharp distinction
between capital controls as an occasional instrument of policy
and capital controls as a continuing fact of life." Giving
the examples of Malaysia (where capital controls were introduced
in 1997) and Chile, he added that "[the] danger if you leave
them on as a fact of life [is that] they will not only cause distortions
in resource allocation, but just general rent-seeking behaviour.
And there is an inducement to corruption."(Ev II, Q 1070).
The downsides of globalisation of the financial
244. Whilst acknowledging the benefits of capital
market liberalisation, a number of witnesses emphasised the problems
it has created. It has been suggested to us that the advantages
for trade and economic growth have been offset (even, perhaps,
more than offset) by the disadvantages to macroeconomic stability
and the management of national debt, and because of greatly increased
financial instability caused by highly volatile short-term capital
245. Stephen King, for example, referred to capital
flows being "a source of instability, particularly when they
go into reverse". He gave the examples of Mexico and Thailand
in the 1990s (Ev I, p 70). George Soros made the same point, giving
Argentina's current predicament as an example (Ev II, Q 1925).
246. Professor Krugman emphasised financial instability
as one of the downsides of globalisation: "The first thing
is capital markets and financial crises. Those have been very
severe. The nineties, I think, was the worst decade since the
thirties for international financial crises." (Ev II, Q 1880).
Andrew Crockett thought that there had been an increase in the
number and severity of episodes of financial distress in recent
years, and the costs of this financial turbulence "
in terms of output foregone ran into double digits as a percentage
of GDP in a significant number of countries
" (Ev I,
247. Paul Volcker, former Chairman of the US Federal
Reserve, whilst noting the "enormous benefits of open markets",
commented: "The ironic thing is that financial markets really
only opened up dramatically in the 1990s, following the break-up
of the Soviet Union and the triumph of the doctrine of open markets
with surprising enthusiasm, as I see it, the emerging
markets joined in this opening and then they pretty promptly fell
on their face." The effect was, and is, that: "The second
half of the 1990s or the latter part of the 1990s and even extending
to now has not matched the growth rate that they had before the
markets were opened." (Ev II, Q 1757). Mr Volcker stressed
that although large developed countries were able to be reasonably
resilient in the face of financial and exchange rate volatility,
this was not true of smaller economies:
my argument is that people do not realise
volatility affects a small open economy
you get a sharp fluctuation in exchange rates in those countries
and you are talking about half the economy being knocked off course
and the exchange rate and the interest rate going up and down
in a wild swing in a way that is not very manageable." (Ev
II, Q 1757).
248. Michael Kitson gave evidence about how technological
developments had encouraged the use of new financial instruments
for speculative purposes because of the speed at which they could
be bought and sold. He noted the problems this had created. This
"hot money", he said, "has led to volatility in
exchange rates and asset prices and has deepened recent currency
crises." (Ev I, p 111). The Royal Society of Edinburgh made
a similar point: "As to the volatility of capital flows,
if everything in the system is speeding up, in large part because
technology is accelerating the process, then there will be increasing
volatility as financial resources seek to flow to where the advantages
are perceived to lie." (Ev II, p 378).
249. War on Want shared this concern. In their memorandum
to the Committee, War on Want stated that "
instability in global financial markets is a serious threat to
any advance in human development." (Ev I, p 376). They continued:
"Governments are finding it increasingly difficult to pursue
independent policies which may be inconsistent with the interests
of global capital, as the case of Brazil shows." (Ev I, p
378). The implication here seems to be that foreign capital flows
are highly sensitive to certain domestic polices, and that there
may therefore be a conflict of interest between lender and borrower.
250. The OECD argued that:
"The case for trade liberalisation is quite
clear. In contrast, the benefits drawn from financial market deregulation
are less obvious. Obviously, an open door to international financial
flows is an important channel to utilise foreign savings and meet
domestic investment needs. This can also spur competition in the
financial sector and lead to efficiency gains. However, financial
market volatility is large (although it is not clear whether it
has increased in the recent past), and many countries have been
subject to financial crises following the sudden withdrawal of
foreign capital or the flight of domestic savings." (Ev I,
251. Tito Mboweni identified the greater volatility
in international capital movements as "
one of the
most important challenges of globalisation to the South African
" (Ev I, p 236). The opening up of South African
financial markets to international competition plus significant
restructuring of the institutional arrangements in the South African
capital markets had "
contributed to a large inflow
of capital but also resulted in greater volatility in the capital
movements between South Africa and the rest of world." (Ev
I, p 235).
252. UNCTAD argued that capital market liberalisation
had been damaging to both the poor developing countries and emerging
"Financial liberalisation did bring greater
capital flows to developing countries in the 1990s, albeit directed
mainly to a handful of emerging markets. But even in these successful
countries, the liberalisation of capital flows, particularly where
it has been prompted by the need to finance growing external deficits,
has actually made matters worse, further impeding investment in
productive physical assets by favouring the short-term on financial
assets. Higher interest payments have added to the difficulties
caused by widening trade deficits, and even the strong growth
of FDI flows to developing countries in the 1990s has been accompanied
by an increased share of mergers and acquisitions as opposed to
greenfield investment, and by investment in sectors characterised
by boom-bust cycles.
On recent trends, the level and composition of net
capital flows received by most developing countries are inadequate
to meet their existing external financing requirements or to contribute
to a higher target rate of growth.
The external financing
needs of developing countries can be expected to exceed recent
net capital inflows by a substantial amount.
Thus globalisation is not working for many developing
countries." (Ev I, p 363).
253. In recent years there has been a removal of
capital controls on a scale which has led to a much greater reliance
on borrowing from abroad. It appears that the problem described
by UNCTAD is not financial liberalisation per se, but external
deficits. These may have been caused by over-ambitious or faulty
domestic policies accompanied by excessive external borrowing.
If that is the case, then this is an argument, in certain cases,
for greater, not lower, capital flows (albeit under favourable
conditions). The problems for the domestic economy are magnified
when the flows are denominated in foreign currency if there is
an adverse movement in the exchange rate. This will require a
large switch of resources to meet external debt obligations. In
the short run, this can be extremely damaging and politically
de-stabilising. Therefore, borrowing large amounts short term
in a foreign currency is almost certainly inadvisable for a country.
It is often done in countries where domestic financial markets
are not sufficiently deep to meet a domestic fiscal crisis, and
hence the long-run solution is a reform of domestic policy. This
does not, of course, address the short-run problem.
254. Another cause for concern, related to financial
instability, is the spread of financial crises from one country
to other countries. Donald McKinnon commented that:
"Globalisation in international capital markets
had resulted in far greater linkages between financial markets
in economies which had liberalised their financial sectors but
this had brought greater risks of financial contagion in a crisis.
A key lesson from the East Asian crisis is that capital
flows, particularly short-term flows, can be extremely volatile.
Furthermore, the herding instinct of investors actually accentuates
crises and fuels contagion." (Ev I, p 303).
He concluded from this that it was important for
developing countries to manage financial market liberalisation
carefully with an appropriate sequence of policies in building
deeper domestic capital markets (Ev I, p 302). Willem Buiter referred
to contagion in financial markets, "manias and panics, irrational
euphoria and despondency" as one of the elements of "pathological
globalisation" (Ev I, p 84), and Sir Howard Davies, Chairman
of the FSA, described how the ease of capital flows and technological
advances meant that "
the financial shock waves of
a major event now transmit to markets on a global basis virtually
instantaneously." (Ev I, p 320). Gerald Holtham said, however,
that he was interested in "how very little contagion there
had been very recently, for example, from the Argentinian crisis"
which has not "even affected Chile or Brazil to any significant
extent" (Ev II, Q 1068). This appears to be a minority view.
255. Stanley Fischer, when he was First Deputy Managing
Director of the IMF, wrote in 1998 in his analysis of the Asian
crisis that: "Contagion to other economies in the region
appeared relentless. Some of the contagion reflected rational
but the amount of exchange rate adjustment
that has taken place far exceeds any reasonable estimate of what
might have been required to correct the initial overvaluation
of the Thai bath, the Indonesian rupiah, and the Korean won, among
Professor Krugman spoke in terms of the current South and Latin
American problems as having a strong element of contagion. This
is particularly so in the case of Brazil, which, although it has
inherited a large debt burden following fiscal deficits in the
early 1990s, currently has a budget surplus, a floating exchange
rate and a strong banking system. Contagion is seen as an important
reason why international financial institutions like the IMF need
to take an active role in crisis management in a country.
256. The evidence supports our view that there
are advantages to capital market liberalisation. Economic theory
and the evidence we have received show, in particular, that capital
market liberalisation is broadly beneficial to the economic progress
of developing countries. It is not without costs, however, and
for developing countries to pursue it without adequate preparation
of the right policies and institutions would be foolhardy. Our
overall conclusion is that the international free flow of capital
should be the aim, and become the norm. However, matching the
timing of capital market liberalisation with the precise circumstances
of the individual country is of the essence.
The international economic
257. Although some blame for global financial instability
and contagion is attributed to national economic policies, much
of the evidence to the Committee tended to stress failures in
the policies of the IMF, the main global economic institution
involved actively in financial and macroeconomic management of
countries. The World Bank was criticised to a lesser extent. We
turn first to the World Bank briefly and then consider the IMF
in more detail.
The World Bank
258. The World Bank was established as part of the
Bretton Woods settlement to assist in financing the re-construction
of war-damaged economies. It is now involved in financing development
more generally. The evidence we received about the performance
of the World Bank was largely positive (especially in comparison
with the IMF), with indications that policy changes within the
Bank in recent years were to be applauded.
259. Lord Desai, for example, said: "all through
the 1990s the World Bank improved immensely in the way it understands
growth, poverty and things like that. I would say that the World
Bank has done much less harm than the IMF has done." (Ev
II, Q 1741). Mathew Taylor MP suggested that although the World
Bank had been "truly awful in the past", it was "undoubtedly
improving" (unlike, Mr Taylor said, the IMF) (Ev II, Q 1385).
260. Professor Stiglitz, a former Chief Economist
at the World bank, told us;
"As I have watched very carefully both the IMF
and the World Bank, I think that there have been much more significant
changes in the World Bank than in the IMF and it goes much deeper
into the organisation, the change in mindset, the change in how
they interact with developing countries. One thing about the World
Bank is that it is very decentralised and the country directors
and the regional vice-presidents have a lot of autonomy."
(Ev II, Q 725).
Nicholas Stern, the current World Bank Chief Economist,
confirmed this change in approach. We asked him about the allegation
made against the World Bank, as well as the IMF, that it applies
a "one-size-fits-all" approach:
"We have made a big effort, particularly in
the last five or six years, to decentralise our activity and put
our country directors in the field. The point of doing that is
that they get closely involved with the real challenges in the
country and they understand the particular environment. As part
of that story of trying to support countries to make their own
choices, we have been backing the approach called the poverty
reduction strategy. There is a poverty reduction strategy paper
which is a process which is built within the country." (Ev
II, Q 1825).
261. Clare Short recognised this change within the
World Bank: "The Bank has, in the last five years
, focused much, much more on the measurable reduction of poverty
being the sign of success in development, empowering local people
and governments to take control of the reform agenda against that
kind of objective with more openness." (Ev II, Q 2022). We
welcome this development.
262. While most of the evidence we received about
the World Bank was positive, some criticisms were made. Dr Yilmaz
Akyuz of UNCTAD, for example, suggested that unlike the IMF which,
because of the Asian financial crisis in 1990s, had gone through
a period of re-thinking, the Bank had failed to progress since
the 1970s or 1980s. The Bank had, he said, "over-stretched
itself" (Ev I, Q 975). It should consider focusing "on
a few areas
maybe go back to project financing
programme lending" (Ev I, Q 976). Paul Volcker shared the
view that the World Bank was attempting to pursue too many objectives:
"I do not criticise them
they are being asked to do
too many things and very few of them are what is clearly within
their grasp. It was quite different
30 years ago: the World
Bank lent on infrastructure." (Ev II, Q 1774).
263. Martin Wolf also alluded to the "extraordinarily
multifarious" and "unbelievably wide-ranging" activities
of the Bank. He suggested that the Bank should concentrate on
two main functions: first, the provision of advice and knowledge
not available from other sources (because the Bank "contains
a vast repository of information and a great many very able people");
and secondly, the provision of funds to countries that have no
access to capital markets to support programmes which those countries
have decided to pursue (Ev II, QQ 1617-18).
264. We note that George Soros, in George Soros
on Globalization, refers to the criticism of the World Bank
by the International Finance Advisory Commission (the Meltzer
Commission) Report: "
the Meltzer Commission criticises
the World Bank for being a bureaucratic organisation with too
large a staff and for engaging in lending activities that could
be taken care of by the capital markets."
Although not wholly supportive of the Commission's recommendations
in relation to the World Bank, Mr Soros endorses the view that
the Bank lending operations should be reformed and should include,
for example, an even greater emphasis on transparency and the
fight against corruption.
265. We started our inquiry from a position highly
critical of the World Bank in its role as an international financial
institution. While acknowledging the criticisms of the Bank, the
evidence has led us to a more balanced and supportive view. In
addition to welcoming the Bank's more client-focused approach
in its operations, we are especially impressed by the World
Bank as a source of data and research which provides the basis
for a sensible and valuable approach to the growth process.
266. The IMF was also created as part of the Bretton
Woods settlement. The Articles of Agreement state that the IMF
seeks to promote international monetary co-operation, facilitate
the expansion of international trade, promote exchange-rate stability
and avoid competitive depreciation.
CRITICISMS OF THE IMF
267. A number of witnesses commented on the harmful
effects that IMF policies had had on developing countries. It
was seen by some as a major cause of the problems arising from
globalisation, and by others as making economic crises in some
developing countries worse. The crises in East Asia, Argentina
and Brazil were frequently cited as examples.
268. Professor McKinnon told the Committee that he
thought that the IMF had "lost its sense of mission".
In the early days of Bretton Woods "
the strong dollar
was at the centre while there was a lack of confidence in European
So the IMF very explicitly committed all the
peripheral countries in Europe and Japan to maintain capital controls.
countries on the periphery and emerging markets
should be able to use capital controls (to stabilise their financial
systems). The IMF's big sin of commission up to a year or two
ago was to be a cheerleader for getting rid of capital controls.
Without capital controls, the stage is set for hot money
flows, which are unnecessary."(Ev I, Q 541). He went on:
"The leaders of the IMF have for the most part been in favour
of free-floating and pushing countries despite these very strong
neighbourhood effects, so that when country A devalues, it really
hurts country B." (Ev I, Q 544).
269. John Grieve Smith, Fellow of Robinson College,
Cambridge, argued in his memorandum to the Committee that "
the IMF should stop prescribing deflationary measures which increase
the risk of massive increase in unemployment in countries in difficulties
and instead help them to stabilise their economies in such a way
as to maintain employment." (Ev I, p 63).
270. Professor Joseph Stiglitz thought that the main
problems with the IMF arose from its governance: "the voices
of all countries are not all equally heard
there is lot of
unhappiness about the UN with five countries having veto power
and in the IMF one country has effective veto power, and that
particular country, I am embarrassed to say, tends to pursue a
position which is increasingly best described as unilateralist
and which itself is dictated by special corporate and financial
interests within the United States" (Ev I, Q 711). Professor
Stiglitz suggested that "basically countries are told [by
the IMF] to adopt a neo-liberal agenda
and this is causing
very severe problems in confidence in democracy and reforms in
many developing countries"; he gave capital liberalisation
as an example of "an agenda that was being pushed by the
IMF and the US Treasury when there was no evidence that it promoted
economic growth." (Ev I, Q 718). In his view "the IMF
needs to focus on the one area of its supposed competence, that
is crises". He went on: "They are beginning to talk
about more use of bankruptcy and standstills and away from big
Stan Fischer on this issue said if you default
it is an abrogation of your debt contract, whereas my view was
that bankruptcy has been a fundamental part of capitalism and
we would not have the market economy we had if we did not have
bankruptcy." (Ev I, Q 733).
271. George Monbiot of The Guardian similarly
focused on governance issues. He said that he "would like
to see the dissolution of the World Bank and the IMF", which
he believed were "profoundly undemocratic organisations,
that people who control them are exclusively the rich nations
and the places in which they work are exclusively the poor nations,
so the recipients of their policies have no effective influence
over their policies" (Ev II, Q 1317). By way of example he
said: "We saw this very clearly with Argentina where the
government and certainly the people had a clear view of the sort
of economic policies they thought would be appropriate. It was
plain the IMF had a different view, the IMF's view prevailed and
we all know what happened." (Ev II, Q 1334).
272. Professor Krugman, speaking about the Argentina,
crisis said: "The sin of the IMF in 1997-98 was that of,
essentially, adopting a crime and punishment point of view of
financial crisis, that if you are having a crisis it must be because
there is something terribly wrong with you and there can be no
recovery without wrenching reform." (Ev II, Q 1883).
THE CHANGING ROLE OF THE IMF
273. The current role of the IMF is very different
from its original purpose. This is partly because the financial
markets have much more influence. Andrew Crockett put it this
"Today, each of these features of the system
- exchange rates, adjustments, and liquidity - are determined
by decentralised decision taking in private financial markets.
Concerns have shifted from traditional macroeconomic imbalances
to the interaction between freer financial markets and the real
economy. Addressing financial instability has risen to the top
of the international policy agenda, both with regards crisis prevention
and management. The effectiveness of the system relies not so
much on whether governments take the right decisions, but on whether
they provide the right framework to enable the private sector
to make the right decisions. The IMF stills plays a key role,
but the number of relevant players has increased including national
standard setters in the financial sphere and their corresponding
international bodies." (Ev I, pp 157-8).
He described the IMF's present role as follows:
"The [IMF and World Bank], while possibly playing
a standard setting role in certain specific areas (eg, transparency
of fiscal and monetary policies), are primarily involved in the
monitoring of countries' policies, and in particular of their
compliance with financial standards. They help countries upgrade
their systems, set priorities among competing demands, and can
be a vehicle for providing information to markets on the state
of financial systems." (Ev I, p 158).
He referred to the constraints the Fund works under
in one of the areas where it receives much criticism:
"The management of sovereign liquidity crises
is one of the Fund's central tasks, but is greatly complicated
by the fact that there is no international counterpart for insolvency
and a lender of last resort in national financial systems. The
IMF therefore has a delicate task in ensuring that private creditors
are involved in crisis resolution in a way that does not exacerbate
moral hazard, or choke off private sector flows for the future."
(Ev I, p 158).
274. Willem Buiter was asked whether he thought the
IMF should be the lender of last resort. He replied: "The
lender of last of resort cannot be done internationally because
it requires supranational institutions of the kind that we just
do not have at a global level." (Ev I, Q 219). He went on
to suggest that the IMF could not do it "because they do
not have the resources or the power" (Ev I, Q 222). Martin
Wolf took a similar view. He said that: "The really interesting
questions [for the IMF] concern its role as a lender, and the
difficulty here is I do not think we have worked out, and it is
not even obvious in theory how we could work out, what precisely
the lending function of such an institution is. It is clearly
not there to save all the lenders. It is not there to ensure that
all lenders get their money out. That would be highly undesirable.
It cannot be a lender of last resort in runs because it does not
have the resources and it is pretty clear it does not have the
capacity to minimise the moral hazard that would be created by
that. So it has a very limited function in that respect."
(Ev II, Q 1628).
275. Referring to what he thought the IMF could do,
Martin Wolf suggested that "
if this institution is
to have any value, [it] is to make as clear as possible and ideally
as publicly as possible when it believes countries are running
into very serious difficulties, so that instead of financing growing
crises, it forestalls them. This is an incredibly difficult thing
for the IMF to do because it will be triggering the crisis it
is supposed to avoid." He added that you have to be able
to deal with a crisis without bailing everybody out. The Fund's
job was to manage default while reducing the extent of the pain
imposed upon the country concerned: "
the right package
of a default plus a willingness to lend to a country
in arrears or in default provided that country is showing real
signs of getting to grips with its problems." (Ev II, Q 1628).
276. Given that by definition all funds moved from
one place must go somewhere else, it is at least worth considering
whether the lender of last resort function could be undertaken
by the leading central banks co-operating under the auspices of
the IMF. The problem, of course, is how to cope with the moral
hazard problem mentioned by Andrew Crockett and Martin Wolf (in
paragraphs 273 and 274 above).
277. We were unable to arrange an evidence session
with Horst Köhler, Managing Director of the IMF. We were
interested to note, however, an article in the Financial Times
in which Kenneth Rogoff, Chief Economist at the IMF, explained
the Fund's role as follows:
"Distressed emerging-market debtors typically
come to the IMF precisely because its financial assistance, combined
with the policies it supports, generally alleviates austerity
rather than intensifying it. Emerging-market debtors typically
come to the IMF only when their finances are under extreme duress
- usually through imprudence and bad luck - and other creditors
have turned their backs. These countries would otherwise have
no choice but to tighten their belts. An IMF loan typically loosens
the belt, both directly via added funds and indirectly by helping
to stabilise markets."
Critics of the IMF, he said, thought that the Fund's
main task was to fight recessions: "They claim that what
the creditors really want is to see growth. Ergo, the best way
to defend a currency is by cutting interest rates to expand the
economy. Similarly, if a country wants to calm creditors, it should
be borrowing more money, not less. They think the resulting growth
would allow the country to carry proportionately more debt. Sadly,
the clear weight of logic and evidence suggests the opposite."
He admitted that "there is a real risk in any IMF programme
that interest rates might be raised too sharply and the path of
fiscal policy set too tight." When it became clear that the
economic downturn in the Asian crisis of 1997-98 was worse than
initially thought "not just by the IMF but also by just about
everyone, the IMF changed its advice to allow fiscal policies
to be less restrictive." He warned that "if the programme
does not embody sufficiently ambitious targets, it will collapse
for lack of credibility." He also drew attention to an important
constraint that the IMF works under: its budget. If it lends to
some countries for longer terms, it is unable to recycle the funds
to other countries. There are, therefore, losers as well as gainers.
Tackling financial instability
278. Central to our consideration of the role of
the IMF in addressing problems of global financial instability,
two distinctions must be made. The first is the distinction between
the long and short term in setting policy; and, the second is
between problems arising from faulty macroeconomic policy and
those arising from forces outside the control of the government
of the country concerned. On the one hand, the IMF can be helpful
to countries in formulating a long-term policy strategy which
is also connected with their short-term response to policy problems.
On the other, the IMF itself can intervene in providing support
when a short-term financial crisis emerges. This intervention
might involve co-operation with the major central banks.
279. Our thoughts on the role of the IMF are based
on the philosophy which underlies the whole of this report: namely,
that it is for countries themselves to determine their objectives
and means of achieving them. The role of outside bodies is not
to take over the macroeconomic governance of a country. It is
to be critical, advisory and supportive. Certainly, it is not
to place obstacles in the path of a country trying to do the right
thing in its own way at its own pace. We emphasise the word "critical".
We see nothing wrong in the IMF saying from time to time, and,
of course, on the basis of evidence, that such and such a policy
on the part of country X has done harm rather than good in the
other cases in which it has been tried. This is especially so
when a good mark, so to speak, awarded by the IMF is likely to
make it easier for a country (or firms in a country) to borrow
both short and long term. To give a country a clean bill of health
when it is not justified is damaging to international financial
markets. Equally to the point, in encouraging poor policies it
may lead to a postponement and magnification of disaster. Having
said that, we reiterate the point that it is not true that only
one policy model is right for all countries at all times. While
our evidence has indicated that the IMF appeared to adopt this
view at some time in the past, it no longer does so.
IMF as a "body for surveillance"
280. Gordon Brown, the Chancellor of the Exchequer,
clearly sees an important role in the future both for prudent
domestic economic management and for the IMF. He told us:
"I do believe that the new modus operandi around
the world is for greater transparency, and in that context the
IMF should see itself more as a body for surveillance which is
reporting on whether codes and standards are being upheld and
whether there is genuine monetary and fiscal transparency and
there are good corporate standards being observed.
is the way forward for the international institutions as well
as the way in which the poorer countries can guarantee that they
can get support, both in terms of international investment and
support from the international institutions." (Ev II, Q 2092).
In his evidence, the Chancellor emphasised the importance
of transparency several times. This is particularly important
in establishing confidence in financial markets so that they are
willing to make long-term, and not just short-term, loans.
281. Mervyn King of the Bank of England emphasised
the need to accompany long-term borrowing with appropriate long-term
if a government claims to be pursuing
the right policies
the impact of that on capital markets
will depend not just on what the government in control on the
day is doing, but on what financial markets expect future governments
to do as well
if the financial markets, taking a longer
term view, feel that it is not sustainable
that is bound
to affect the way [they] reach their judgement." (Ev II,
Q 2051); and
lenders take a long-term view of what
a country will do. ... It is difficult to borrow long term unless
you have a framework for policy and an infrastructure in society
which enables a country that is borrowing to make an equally long-term
commitment to the lenders, and if it is not able to do that, perhaps
it should not be looking to borrow quite so much long term from
abroad." (Ev II, Q 2052).
Bail-outs and Bankruptcy
282. Bail-outs and bankruptcy provide mechanisms
for re-structuring sovereign debt in the presence of an immediate
crisis. Increased borrowing or lengthening the maturity structure
of debt would resolve an immediate problem in most cases. It is,
however, because a country is unable to do this that a problem
becomes a crisis. Most of the debt obligations are to private
sector banks and other financial institutions. They take the form
of syndicated loans, or bonds in emerging market debt. Understandably,
given the high-risk nature of additional loans, private investors
are reluctant to commit additional resources, or re-schedule debts,
without guarantees, or some way of spreading the risks.
283. We have noted (in paragraphs 273-76 above) how
the IMF might provide emergency finance by providing a lender
of last resort facility, subject to the problem of moral hazard.
To some extent it does already but, as explained by Kenneth Rogoff
, the main problem the IMF faces is that it has limited resources
and these have to be re-cycled. The Treasury, in its supplementary
evidence, endorsed Willem Buiter's view that the supranational
institution of the kind needed to deal with the problem of lack
of loanable funds did not exist. They wrote: "In a world
of globalised financial markets, the official sector does not
have sufficient resources to provide large-scale bail-out packages
as a standard response to emerging market crises." (Ev II,
p 270). The Committee acknowledges the constraints that the IMF
works under in providing short-term finance.
284. There seems to be no good reason to rule out
a free-market solution involving obtaining the additional funds
from the world's capital markets. It is, however, the increasing
reliance on international capital flows and the failure of the
world's capital markets to come to the rescue of countries in
crisis that lies at the heart of criticisms of global financial
285. The key to a free-market solution is to deal
with the legal problems arising from re-scheduling debt, to find
a way to price default-risk and to develop insurance vehicles
for creditors. A country's debt is not necessarily held by a single
creditor, but is shared among several. A problem that can occur
in re-scheduling debt arises from the fact that it may require
a change in a legal contract which is difficult to obtain in some
countries. As a result, even minor creditors can disrupt re-scheduling
286. Default is an extreme form of re-structuring
debt. Its attraction for a country is that it immediately removes
its debt service requirements as well as its long-term obligations.
Debt-forgiveness is another way of removing long-term obligations.
The UK government has been taking a leading role in advocating
debt forgiveness as amongst other possible measures in debt re-scheduling.
The Chancellor told the Committee that "a new international
bankruptcy procedure to deal with unsustainable debt" was
needed as part of a better framework for crisis prevention and
resolution (Ev II, Q 2088).
287. Less extreme measures are standstills to suspend
debt service payments and to write down debt obligations. Like
debt-forgiveness, writing down debt, which reduces the size of
the debt obligation but does not eliminate it, may be very beneficial
in obtaining a sustainable long-run solution. As noted in paragraph
270 above, Professor Stiglitz has said that the IMF needs to give
these types of solution closer consideration. In fact they are.
The IMF and World Bank are currently examining the legal problems
of re-structuring debt and the issue of default.
288. The Chancellor told the Committee that the IMF
and the Group of 7 (G7) countries are actively engaged in finding
new solutions to these pressing problems. In November 2001, the
IMF proposed that a new Sovereign Debt Restructuring Mechanism
(SDRM) be established. The Treasury's supplementary evidence to
the Committee reports that there are four main components of this:
(i) temporary protection from creditor litigation; (ii) establishing
a mechanism to facilitate debtor-creditor negotiations; (iii)
granting seniority to creditors during the restructuring period;
and, (iv) a mechanism to bind minority creditors to the agreement.
The Treasury states that: "The UK, along with the rest of
the G7, has pledged its support for further work to develop this
proposal." (Ev II, p 226).
289. Aside from that, part of the aim must be for
financial markets to develop new ways to spread the risk to the
lender arising from sovereign debt problems more widely across
the world financial markets. Financial instruments are required
that price default risk as they do other forms of risk. Instruments
are also needed to provide the creditor with insurance in the
case of default or non-performing assets. Credit derivatives,
such as credit default swaps are an example of the latter. It
would take a systemic failure of world capital markets on a large
scale to prevent this type of risk-sharing from working. Even
if these facilities were developed, the ultimate source of risk
would still stem largely from individual country macroeconomic
policies. This would be costly to a country as it would tend to
create a country-specific risk premium.
290. This type of solution, whether it take the form
of debt-forgiveness or debt-restructuring, again carries with
it the problem of moral hazard: it increases the incentive to
the borrower to incur more debt and to undertake more risky investments
in the knowledge that it will be bailed out, or the lender has
insurance. The problem of moral hazard makes it essential to write
appropriate contracts and for them to be enforceable. This is
an active area of research in international finance.
291. There is no doubt that the IMF has made mistakes
in the past. It has admitted as much. We have noted that it is
re-examining many of its policies, including whether it is always
appropriate to recommend the removal, or non-imposition, of capital
controls. And it is working on better mechanisms for sovereign
debt re-structuring. The Committee was told by some witnesses
that the IMF should be abolished, but we do not want to see the
abolition of the IMF. We agree with the general view that were
it not to exist, it would have to be re-invented. We believe that
the IMF has a crucial role to play. We note the Chancellor's view
that "[t]he role of the IMF is increasingly about surveillance
and monitoring the transparency of individual national policies
and publicising that surveillance. Where previously it used to
be in secret rather than published, it is far better that it is
out there and open and above board what the views of these experts
are." (Ev II, Q 2108).
292. We believe that the IMF is the appropriate
body to assist a country faced with an immediate financial crisis.
We say this whilst recognising and sharing the criticism of some
of the IMF's past interventions. We are aware that in the past
the IMF has been seen as being part of the problem rather than
the solution. We are glad to note that they have for some time
been subjecting their procedures to internal scrutiny, especially
as they pertain to dealing with short-term financial crises. In
the short term, what is obviously required is immediate assistance
to deal with impending sovereign debt default. We recognise that
the resources of the IMF are limited and that, therefore, financial
support from the United States and other developed countries will
have to increase and the role of the main central banks be enhanced.
We also recognise the advantages of involving the world's capital
markets in providing the necessary short-term finance, and the
important role that the IMF can play in sovereign debt re-scheduling.
Finally, it is our general view the IMF should pursue an open-minded
approach to these problems and one that is carefully tuned to
the circumstances of individual countries.
Capital transactions tax
293. There is a view held by many economists that
financial markets, national and international, show excess volatility
even in the presence of sound macroeconomic policies.
One solution to this has been a capital transactions tax (CTT)
or Tobin tax.
294. A CTT permits access to world capital markets
but aims to limit their volatility by taxing movements in capital.
War on Want stated that a Tobin tax "
is a pivotal
issue for our times. The tax is both necessary, in order to deal
with the risks of currency crises, and entirely possible, on a
practical political level. It would make considerable sums available
for global aid for sustainable development, which continues to
suffer from chronic under-funding." (Ev I, p 381). They also
said: "A CTT set at the right level should neatly discriminate
between short-term investors - who typically undertake numerous
currency speculations daily - and longer-term investors carrying
out single foreign exchange transactions." (Ev I, p 379).
War on Want do not, however, argue that "a CTT alone, even
applied internationally, is an adequate measure to address global
financial instability" (Ev I, p 379). Rob Cartridge, Campaigns
Director for War on Want, told the Committee that "a Tobin
tax is not a panacea", and added that War on Want was "not
opposed to free and floating exchange rates" (Ev I, Q 995).
295. Rodney Schmidt, North South Institute, Canada,
said that "the Tobin tax is relevant to a crisis which occurs
by reason of an external shock, by reason of ad hoc movements
in international foreign exchange markets." (Ev I, Q1008).
Asked about how the tax would be collected, Mr Schmidt said by
taxing all inter-bank and retail market foreign exchange transactions
through the settlement system (Ev I, Q1027).
296. Demonstrating the size of capital flows, War
on Want noted in their memorandum that currency market trading
dwarfs trade, central bank reserves and FDI flows to developing
countries (Ev I, p 376).
They also noted that "80 per cent of global forex transactions
take place in seven cities around the world: London, New York,
Hong-Kong, Singapore, Frankfurt and Berne. The City of London
alone accounts for 32 per cent of the total." (Ev I, p 379).
297. There was no virtually no support from other
witnesses for a CTT.
The Committee have various concerns about a Tobin tax: the consequences
of it not being imposed simultaneously in all countries thereby
allowing non-participating countries a huge advantage; the difficulty
of collecting the tax; and, the potentially harmful effects on
hedging foreign exchange risk through discouraging short-term
positions. We also note that although capital flows are large
relative to trade and reserves, the currency movements and the
financial centres involved are almost entirely in countries with
stable currencies for whom short-term capital volatility is not
298. Thus, if the main aim of the CTT is to stabilise
world capital mobility and currencies, then it misses its target.
If the aim is to apply it in countries that are particularly vulnerable
to capital flight, then the danger is that it will make short-term
borrowing, usually an emergency measure, much more difficult to
acquire. If the aim is to generate aid for development purposes,
then it is not at all clear that throwing sand into the financial
system is the right way to do it. It is significant that Professor
James Tobin, who originally proposed the tax, withdrew his support
for the idea. The Chancellor put it this way: "Before he
died Professor Tobin distanced himself from the apostles of the
Tobin tax. The reason was that the Tobin tax was conceived in
a different world of capital markets that were basically national
and regulated. He thought, at the time, it was quite easy to impose
a transactions tax. In actual fact, in a highly liberalised market,
that is not regulated in the same way as it was by national governments
in 1970s and 1980s, it is far more difficult to impose this anyway."
(Ev I, Q 2105). Sir Edward George, Governor of the Bank of England,
said that he was not an enthusiast of a Tobin tax in general.
He said he thought some capital flows are good and some are bad
and a Tobin tax could not distinguish between the two. He thought
on the Tobin tax is practicality, because
foreign exchange markets can go anywhere in the world
you would divert a lot of foreign exchange market activity to
places that did not apply the tax. I think that is not a productive
thing to do" (Ev II, Q 2054).
299. The Committee is not persuaded of the case
for a Capital Transactions Tax as a mechanism for reducing capital
market volatility. It would be difficult, if not impossible, to
impose world-wide and could be very harmful to a country to do
so on its own. We recognise that capital outflows can be damaging
to an economy, but this is often a symptom of domestic macroeconomic
problems, not the cause. Where, however, capital outflows are
the result of excess volatility and the irrationality of international
financial markets, the IMF, together with the major central banks,
should assist in reducing that volatility. First, it could
announce that it views market behaviour in the case in point not
to be based on underlying reality; and, secondly, since by definition
all outflows have corresponding inflows, the IMF - while lacking
sufficient funds itself - could still help to organise a lender
of last resort response on the part of the central banks acting
jointly. Of course, all this depends on being able in practice
to determine the cause of the outflows in the first place. But
if we cannot distinguish sensible domestic economic management
from what is unsound, there seems little value in having the IMF
in the first place. In sum, the aim should be to address the cause,
not the symptoms.
138 Centre for Economic Policy Research, Making
Sense of Globalization: A Guide to the Economic Issues, Policy
Paper No 8, July 2002, p 27. Back
Philippe Legrain, Open World: the Truth About Globalisation
(2002), p 104. Back
The pursuit of full employment was central to Bretton Woods and
post-war policy making up to the mid-1970s. The collapse of Bretton
Woods was accompanied, coincidentally or otherwise, by rising
unemployment for two decades, and the emergence of low inflation
as a - or the - main macroeconomic objective. Back
European Commission, Responses to the Challenges of Globalisation:
A Study on the International Monetary and Financial System and
on Financing for Development, SEC (2002), 14 Feb 2002, p 25,
and see Michael Kitson, Ev I, p 111. Back
In the cross-Departmental memorandum (Ev I, p 9), Departments
were asked whether volatility had increased in the last 10 or
20 years. They suggested that there was "room for debate"
and cited a number of studies which offered a complex comparative
picture of the Bretton Woods and post-Bretton Woods level of volatility.
For example, they referred to Bordo et al, "Is the Crisis
Problem Growing More Severe?" Mimeo, December 2000, which
demonstrates that crisis frequency since 1973 was double that
during the Bretton Woods era and Gold Standard periods but that
there was little evidence to suggest that crises were now more
Footnote not included. George Soros was similarly ambivalent about
the benefits of capital market liberalisation: liberalisation
has benefits - wealth aggregation and empowering individual states
- but it also has "great disadvantages": and one of
these disadvantages is instability in the global financial markets
(Ev II, Q 1925). Back
"The Asian Crisis", Address to the Midwinter Conference
of the Bankers' Association for Foreign Trade, January 1998. Back
George Soros on Globalization (2002), p 101 (original footnote
not included), referring to the report of the International Financial
Institution Advisory Commission (The Melzer Commission), March
27 September 2002. Back
On 25 September 2002, in an after-dinner speech at Lancaster House,
Dr Alan Greenspan spoke about the potential importance of using
credit default swaps to insure against default risk. This is a
new but rapidly emerging financial instrument. Back
The question arises: what is the IMF to do when the source of
the problem is the pursuit of erroneous policies on the part of
a sovereign government? It is obvious that if a crisis occurs,
the job of the IMF is not to make things worse. It is equally
obvious that bail-outs should not be used to enable the country
in question to continue with unsound policies or to encourage
other countries to follow suit. In other words, the moral hazard
problem needs to be resolved. Back
On excess volatility, the locus classicus is Robert J Shiller,
"Do stock prices move too much to be justified by subsequent
changes in dividends?" American Economic Review, 1981,
vol 71, pp 421-35.. Back
War on Want, quoting the IMF World Outlook, October 2001,
and the World Bank, Global Development Finance, 2000, state
that while world exports were around US$7.7 trillion annually
in 2001, daily turnover in currency markets is around US$1.2 trillion
and FDI to developing countries in 2000 was US$178 billion. Back
We note, however, that Martin Hattersley, former President of
the Economics Society of Northern Alberta and former Leader of
the Social Credit Party of Canada, suggested that "the idea
of a 'Tobin tax' to place a cost on [speculative] international
(Ev II, p 267). Also, Mr Jeremy Wright argued that a Tobin tax
should be introduced in respect of all speculative currency transactions
(Ev II, p 355). Back