oversight

International Financial Crises: Efforts to Anticipate, Avoid, and Resolve Sovereign Crises

Published by the Government Accountability Office on 1997-07-07.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                       United States General Accounting Office

GAO                    Report to the Chairman, Committee on
                       Banking and Financial Services, House
                       of Representatives


July 1997
                       INTERNATIONAL
                       FINANCIAL CRISES
                       Efforts to Anticipate,
                       Avoid, and Resolve
                       Sovereign Crises




GAO/GGD/NSIAD-97-168
      United States
GAO   General Accounting Office
      Washington, D.C. 20548

      General Government Division

      B-276469

      July 7, 1997

      The Honorable James A. Leach
      Chairman, Committee on Banking
        and Financial Services
      House of Representatives

      Dear Mr. Chairman:

      This report responds to your request concerning the advantages and disadvantages of initiatives
      and proposals to anticipate, avoid, and resolve future sovereign financial crises that might pose
      a threat to the international financial system. The report (1) identifies capital market and other
      mechanisms that are used to anticipate, avoid, and resolve sovereign financial crises as well as
      any limitations of these mechanisms; (2) assesses initiatives that international financial
      institutions and others are developing to improve anticipation and avoidance mechanisms; and
      (3) evaluates initiatives and proposals to improve methods of resolving sovereign financial
      crises.

      We are sending copies of this report to the Ranking Minority Member of your committee, the
      appropriate congressional committees, the executive branch agencies, the international
      financial institution officials, and other interested parties. We will also make copies available to
      others on request.

      This report was prepared under the direction of Susan Westin, Assistant Director, Financial
      Institutions and Markets Issues. Major contributors to this report are listed in appendix V. If you
      have any questions, please call me at (202) 512-8678.

      Sincerely yours,




      Thomas J. McCool
      Associate Director
      Financial Institutions
        and Markets Issues
Executive Summary


             Mexico’s 1994-95 financial crisis has prompted efforts by the Group of
Purpose      Seven countries (G-7)1 to seek ways to improve the capability of the
             International Monetary Fund (IMF),2 other official sector organizations,3
             and capital market participants to prevent or respond to sovereign
             financial crises—situations where countries have been unable or unwilling
             to pay their debts and, as a result, have lost access to global capital
             markets. Because of concern about anticipating, avoiding, and resolving
             crises of comparable magnitude to Mexico’s recent financial crisis, the
             Chairman of the House Committee on Banking and Financial Services
             asked GAO to review improvement efforts in these areas by international
             financial institutions and the industrialized democracies.4

             In this report, GAO identified factors that may increase or decrease the
             probability that a future sovereign financial crisis will threaten the stability
             of the international financial system and identified limitations of current
             market and governmental mechanisms for preventing and resolving
             sovereign financial crises. GAO also evaluated initiatives and proposals of
             the G-75 and others to better (1) anticipate and avoid future sovereign
             financial crises and (2) resolve these crises when they threaten the
             international financial system. GAO focused primarily on those proposals
             that have been implemented or are in the process of being implemented.
             These proposals include the establishment by IMF of voluntary standards
             that countries may use when disclosing economic and financial data to the
             public; an expansion of the General Arrangements to Borrow, which are
             lines of credit that IMF maintains with the Group of Ten countries (G-10);6



             1
              The G-7 consists of seven major industrialized countries that consult on general economic and
             financial matters. The seven countries are: Canada, France, Germany, Italy, Japan, the United
             Kingdom, and the United States.
             2
              IMF is an organization of 181 member countries that was established to promote international
             monetary cooperation, promote exchange rate stability, and provide short-term lending to member
             countries that experience balance-of-payments difficulties. IMF is funded by its members who make
             contributions on the basis of the size of their economies. IMF’s Executive Board is the primary
             decisionmaking body, which comprises 24 Executive Directors who represent IMF member countries.
             3
              The official sector includes international financial organizations, such as IMF, the World Bank, and
             the Bank for International Settlements, and sovereign governments, such as the United States.
             4
              In connection with the Chairman’s request, GAO has already issued a report entitled Mexico’s
             Financial Crisis: Origins, Awareness, Assistance, and Initial Efforts to Recover (GAO/GGD-96-56,
             Feb. 23, 1996).
             5
               These proposals are the products of the 1995 Halifax, Nova Scotia, G-7 economic summit and are
             contained in the communique issued at the summit.
             6
               The G-10 consists of 11 countries, which are the G-7 countries plus Belgium, the Netherlands, Sweden,
             and Switzerland.



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             Executive Summary




             and an expedited IMF decisionmaking procedure to extend financing in
             exceptional circumstances to member countries.


             The international financial system brings borrowers of capital into contact
Background   with lenders in their own country or other countries, thereby facilitating
             the global availability of capital. In the last decade, as the international
             financial system has grown, many of the larger and more economically
             advanced developing countries, often called “emerging market” countries,
             have become increasingly important participants in the system. These
             countries generally have benefited from this inclusion but, in some cases,
             sovereign financial crises have occurred. These crises have harmed the
             debtor countries because they often have been accompanied by recession
             and loss of access to world capital markets. The crises also have harmed
             some creditors of such countries because they have not been repaid on
             schedule or in full.

             Although the effects of a sovereign financial crisis may be limited to the
             debtor country and its creditors, some of these crises, such as Mexico’s
             1994-95 crisis, have affected other countries’ financial and economic
             situations. This has occurred through a “contagion effect” when, in
             response to a crisis in one country, investors removed their funds from
             other countries. It can be difficult to predict whether and to what extent
             contagion will occur in a sovereign financial crisis and how long the
             contagion will last.

             Some past crises also have posed a “systemic risk” to the international
             financial system. Systemic risk is the risk that a financial disturbance,
             which triggers substantial unanticipated changes in the prices of financial
             assets, may seriously harm the financial position of large financial firms,
             which in turn, could threaten to disrupt the global payments system7 and
             the capacity of the international financial system to efficiently allocate
             capital. Department of the Treasury officials told GAO that systemic risk
             could also arise—even without disruption to the payments system—if an
             economic or financial shock were to lead to a sharp curtailment of capital
             markets’ willingness to extend credit to a large number of countries
             despite their having relatively strong economic policies and performances.
             The precise extent to which the international financial system is
             vulnerable to systemic risk is subject to debate, and the degree of systemic



             7
              The global payments system creates the means for transferring money between suppliers and users of
             funds, usually by exchanging debits or credits among financial institutions.



             Page 3                                  GAO/GGD/NSIAD-97-168 International Financial Crises
Executive Summary




risk that a particular sovereign financial crisis could pose is difficult to
determine.

In addition to these uncertainties, which have complicated decisions by
the official sector over whether to intervene in a sovereign financial crisis
to contain contagion and/or minimize systemic risk, a concern exists that
intervention may create or increase “moral hazard.” Moral hazard occurs
when investors or debtor countries alter their financial decisions on the
basis of a belief that the official sector will supply financial assistance to
them in a crisis. Debtor countries may pursue risky economic or financial
policies with the expectation that, if those policies lead to a financial
crisis, debtor countries will not have to pay the full costs of their debts and
investors will not lose the full amount invested. As is true with systemic
risk, it is difficult to measure the degree of moral hazard present in any
given situation and the effect on moral hazard of providing financial
assistance in a particular crisis.

In large measure, the official sector determines whether to intervene in a
sovereign financial crisis by weighing the trade-offs between stemming
contagion and minimizing systemic risk to the international financial
system and creating or by increasing moral hazard for investors or debtor
countries. Mexico’s 1994-95 crisis highlighted the effects of this trade-off
because the need to contain the crisis’ contagion was cited by the U.S.
government and IMF as one justification for providing financial assistance,
while critics of the assistance cited the increased moral hazard that they
believed the assistance created.

To achieve its objectives, GAO interviewed officials from Treasury and the
Federal Reserve Board; IMF; investment and commercial banks based in
the United States; U.S.-based emerging market bond and equity funds; and
experts in the areas of international finance, economics, and law at
universities and private organizations. GAO also developed a conceptual
framework containing a number of elements to assess the advantages and
disadvantages of improvement initiatives and proposals. In particular, GAO
used this framework to analyze the trade-offs among different elements,
such as resolving crises quickly, minimizing moral hazard, and sharing the
burden of resolving crises. In addition, GAO reviewed U.S. government,
international organization, and private firm documents, including
testimony, reports, books, and laws.




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                   Executive Summary




                   The possibility that a future sovereign financial crisis may threaten the
Results in Brief   stability of the international financial system cannot be ruled out, and
                   current mechanisms to anticipate, avoid, and resolve crises have
                   limitations. Although some factors may have lessened the likelihood of
                   such a systemic crisis, such as a recent decrease in potentially volatile
                   portfolio investments in emerging market countries, other factors may
                   have raised the likelihood of such a crisis, including continuing large funds
                   flows into these countries, which may amplify the magnitude of individual
                   crises. One limitation of mechanisms used to anticipate sovereign financial
                   crises is that countries do not always supply the necessary information for
                   market participants to accurately assess investment risks. Resolving crises
                   can be impeded by, among other factors, investors’ actions that may
                   deepen the crisis if they quickly remove their funds from a country in
                   crisis, and by IMF and creditor countries’ governments having difficulty
                   deciding whether to intervene to help resolve the crisis.

                   G-7 country initiatives may help anticipate and avoid some crises, but a
                   number of obstacles may hinder the potential effectiveness of these
                   initiatives. For example, IMF has developed a voluntary standard to
                   improve countries’ public disclosures of economic and financial data.
                   Although IMF intends to enforce adherence to the standard, an IMF official
                   told GAO that IMF lacks the authority and the resources to ensure the
                   accuracy of these data and plans only limited monitoring to check for
                   adherence to the data standards. Instead, IMF has stated its intention to
                   rely on financial markets to monitor and enforce compliance with the
                   standards by removing funds from countries that financial market
                   participants believe have suspect data.

                   The G-7 has proposed an initiative to expand the General Arrangements to
                   Borrow8 to quickly make more resources available to help resolve
                   sovereign financial crises that threaten the international financial system.
                   The expanded lines of credit, which are to be called the New
                   Arrangements to Borrow, would more than double the number of
                   participating countries and increase the total funds potentially available
                   from about $23.8 billion to about $47.6 billion. GAO’s analysis indicated that
                   this initiative could reduce the U.S. share of the burden of resolving future
                   crises, but its use would involve several trade-offs for the United States.

                   Under this proposed initiative, the U.S. share would be slightly less than 20
                   percent of the new arrangements’ funds, down from 25 percent under the

                   8
                    The General Arrangements to Borrow are contingent lines of credit that IMF maintains with the 11 G-10
                   countries and, under a separate arrangement, Saudi Arabia.



                   Page 5                                   GAO/GGD/NSIAD-97-168 International Financial Crises
                             Executive Summary




                             General Arrangements to Borrow. However, although the U.S. share of the
                             lines of credit would fall, the actual amount of funds the United States
                             would contribute to the new lines of credit would increase. This increased
                             U.S. commitment would require congressional authorization and an
                             appropriation of $3.4 billion. However, a senior Treasury official told us
                             that the additional commitment would not affect the size of the U.S.
                             budget deficit because the budget treats the transfer of dollars to IMF as
                             being offset by the U.S. receipt of a monetary asset (i.e., a liquid,
                             interest-bearing claim on IMF that is backed by IMF’s financial position,
                             including its holdings of gold).

                             Use of the New Arrangements to Borrow would reduce the U.S. share of
                             sovereign financial crisis resolution funding compared to the 51-percent
                             share that the United States contributed to the 1995 multilateral financial
                             assistance to Mexico. However, the reduced U.S. participation in the new
                             arrangements could dilute U.S. influence by decreasing its voting power,
                             which might make it harder for the United States to influence activation of
                             the lines of credit by IMF. Similarly, the increase in participants could make
                             it more difficult to obtain a consensus to use the lines of credit to stem
                             contagion. Use of the lines of credit could help to stem a crisis’ spread to
                             other countries and forestall systemic risk, but such use could also
                             increase investors’ or countries’ moral hazard.



GAO Analysis

Future Systemic Crises Are   Some factors may have lessened the likelihood that a future sovereign
Possible and Existing        financial crisis will threaten the stability of the international financial
Mechanisms to Anticipate,    system, such as a recent decrease in potentially volatile portfolio
                             investments in emerging market countries and a greater diversity in the
Avoid, and Resolve Crises    sources of investments. However, Treasury officials emphasized that other
Have Limitations             factors may have increased the probability of such a crisis, including
                             continuing large funds flows into these countries that may amplify the
                             magnitude of individual crises, various trends that may contribute to the
                             volatility of these funds, and the growing ability of countries to run large
                             current account9 deficits because private markets will finance the deficits.
                             Total net private capital inflows to emerging market countries increased
                             by more than threefold between 1990 and 1996, from about $60.1 billion to
                             $193.6 billion. Thus, the possibility that a future sovereign financial crisis

                             9
                              A country’s current account measures its transactions with other countries’ transactions in goods,
                             services, investment income, and other transfers.



                             Page 6                                   GAO/GGD/NSIAD-97-168 International Financial Crises
                           Executive Summary




                           may threaten the stability of the international financial system cannot be
                           ruled out. Treasury officials also said that many of the factors that
                           increase the likelihood of a systemic crisis may also produce crises that
                           would require more substantial official sector resources for their
                           containment.

                           Current market and governmental mechanisms to anticipate, avoid, and
                           resolve sovereign financial crises have limitations. As GAO learned in its
                           review of Mexico’s 1994-95 financial crisis, sovereign financial crises have
                           been complex economic, financial, and political events that were difficult
                           to predict. Capital market participants discipline countries that pursue
                           what the participants perceive to be inappropriate economic or financial
                           policies by lending to those countries with unsound or inappropriate
                           policies only at higher interest rates. The increase in the cost of
                           borrowing, along with the possibility that investors may stop lending funds
                           altogether, can provide the incentive for a country’s authorities to correct
                           their policies, which could help avoid a sovereign financial crisis. Yet,
                           capital market participants GAO interviewed said that sometimes countries
                           do not supply, and investors have trouble obtaining from other sources,
                           the necessary information for market participants to accurately assess
                           investment risks. Furthermore, resolving crises can be hindered by, among
                           other factors, investors’ deepening the crisis by quickly removing their
                           funds from a country in crisis. Also, GAO’s analysis indicated that IMF and
                           creditor countries’ governments may have difficulty deciding whether to
                           intervene to help resolve a crisis because at the same time they are
                           debating whether the crisis warrants intervention, they are also
                           considering the extent to which intervention could exacerbate moral
                           hazard. Therefore, once creditor countries’ governments and IMF decide to
                           intervene, they may not have enough time to provide debtor countries with
                           sufficient financial assistance to arrest a crisis.


Initiatives May Help       GAO’s analysis indicated that the G-7 country initiatives to aid in crisis
Strengthen Crisis          anticipation and avoidance have the potential to help anticipate some
Anticipation and           crises, but obstacles may hinder the initiatives’ full effectiveness. For
                           example, to help improve the economic and financial data needed by
Avoidance, but Obstacles   market participants, IMF has developed a voluntary standard that countries
May Impede Their           may use when disclosing such data to the public. If countries provide
Effectiveness              these data in an accurate and timely way, then the standard should help to
                           improve country data to financial markets, according to some market
                           participants GAO interviewed. As of May 21, 1997, 42 countries had
                           subscribed to the IMF standard, including a number of developing



                           Page 7                        GAO/GGD/NSIAD-97-168 International Financial Crises
                          Executive Summary




                          countries, such as Argentina, Malaysia, Mexico, the Philippines, and
                          Thailand. IMF began allowing countries to subscribe to the standard in
                          April 1996.

                          To enforce adherence to the standard by subscribing countries, IMF has
                          stated its intention to remove from the list of subscribing countries any
                          nation that does not comply with the standard’s specifications, although at
                          the time of GAO’s review, no countries had been removed from the list. IMF
                          intends to rely on capital market participants to monitor and enforce
                          countries’ adherence to the standards because IMF said it lacks the
                          authority and resources to verify the country data. Some market
                          participants told GAO (1) that market participants, for the most part, do not
                          intend to monitor countries’ compliance with IMF’s data standards and
                          (2) that they generally do not expect to keep IMF informed of any
                          compliance concerns they may have. Furthermore, financial markets’
                          ability to discipline countries’ policies to avoid sovereign financial crises
                          has varied, as Mexico’s 1994-95 crisis made evident. The absence of any
                          ready means to monitor and enforce compliance with IMF’s data
                          dissemination standard may limit how well the standard actually improves
                          country data. Furthermore, IMF has no system in place to regularly track
                          market participants’ concerns over compliance.


IMF Initiatives for       Two G-7 initiatives would seek to make more resources available to IMF and
Resolving Crises Would    to make these resources available more quickly in a sovereign financial
Involve U.S. Trade-Offs   crisis. GAO’s analysis indicates that these initiatives would involve some
                          trade-offs for the United States. Under one initiative, IMF plans to more
Relative to Stemming      than double the number of participants in the General Arrangements to
Contagion, Burden         Borrow lines of credit and double the resources potentially available
Sharing, and Minimizing   under the lines of credit. Under the New Arrangements to Borrow, the
Moral Hazard              number of members would be increased from 11 to 25 countries, and the
                          amount of credit available would grow from about $23.8 billion to about
                          $47.6 billion.10 A congressional appropriation of $3.4 billion would be
                          required to fund the U.S. portion of the expansion. The new lines of credit
                          could be activated when participants, representing 80 percent of the credit
                          lines’ resources, determine that there is a threat to the international
                          financial system and that IMF lacks the resources to provide the needed
                          funds.


                          10
                           Dollar values are converted from Special Drawing Rights (SDR) at the rate of 1.40 SDRs per dollar.
                          (GAO took the May 30, 1997, rate of 1.3918 SDR/dollar and rounded it up to 1.4 SDR/dollar.) SDR is a unit
                          of account that IMF uses to denominate all of its transactions. Its value comprises a weighted average
                          of the value of five currencies, of which the U.S. dollar has the largest share.



                          Page 8                                    GAO/GGD/NSIAD-97-168 International Financial Crises
Executive Summary




GAO notes that, although the New Arrangements to Borrow would increase
the official resources available to help resolve sovereign financial crises
that may have a contagion effect on other countries’ finances or that may
pose some risk to the international financial system, U.S. influence in
decisions to use the new lines of credit could be reduced, and the
existence or use of the arrangement might worsen moral hazard.

Because the U.S. proportional share of the new lines of credit is to fall
from 25 percent under the general arrangement to about 20 percent, U.S.
voting share would decrease, and hence the United States’ influence might
be diminished. Similarly, the larger number of countries in the New
Arrangements to Borrow could complicate activation, since more
countries will likely have to consent to activate the new lines of credit.

However, to the extent that the new lines of credit can be activated by its
participants, the United States might be less likely to be called on
unilaterally to provide financial assistance to countries in financial
trouble. On the other hand, to the extent that the expanded arrangements
are difficult to activate, the United States may continue to face the difficult
decision of whether to act unilaterally to assist financially troubled
countries.

Furthermore, while activation of the New Arrangements to Borrow could
stem contagion in a crisis, use of these funds could also exacerbate moral
hazard for investors and debtor countries. However, the United States
would more easily be able to block activation of the new lines of credit
because their activation would require the votes of countries holding
80 percent of the new arrangements’ resources, which is up from
60 percent under the General Arrangements to Borrow. Therefore, the
United States, with its almost 20-percent share, would be able to prevent
use of the lines of credit if it had the support of any one other large New
Arrangements to Borrow participating country or two small participants.
Treasury officials told GAO that moral hazard cannot be entirely eliminated
but that it can be held to a minimum if official intervention in sovereign
financial crises is rare and limited to exceptional circumstances. They also
said that some moral hazard already exists due to the presence of IMF and
other official sector organizations that provide financing to countries in
crisis, but that policy conditionality and phasing of disbursements helps to
limit that moral hazard.

IMFhas implemented a second G-7 initiative that allows IMF’s Executive
Directors to expedite the Board’s decisionmaking procedure to extend



Page 9                          GAO/GGD/NSIAD-97-168 International Financial Crises
                  Executive Summary




                  financing to member countries. Called the emergency financing
                  mechanism, use of the new procedure is limited to extraordinary
                  situations that threaten member countries’ financial stability, that have
                  significant risks of contagion, and that require accelerated IMF-debtor
                  country negotiations. The decisionmaking mechanism, among other
                  purposes, is designed to help provide a speedy official response to stem
                  contagion effects on financial markets in other countries and, possibly, to
                  forestall or mitigate international systemic risk.

                  In some sovereign financial crisis situations, a faster IMF decisionmaking
                  process could, by reducing systemic risk, reduce pressure on the United
                  States to act unilaterally. However, the emergency mechanism may not
                  facilitate speedier funding decisions because it may not lessen
                  disagreement among IMF Executive Directors about the seriousness (i.e.,
                  the extent of potential contagion or systemic risk) of any particular crisis
                  they confront.


                  GAO   is not making any recommendations in this report.
Recommendation
                  GAO  obtained written comments on a draft of this report from Treasury and
Agency Comments   the Federal Reserve. These comments are described in chapter 1. Both
                  Treasury and the Federal Reserve generally said that the report was a
                  constructive and reasonably comprehensive contribution to the analysis of
                  the issues. Both Treasury and the Federal Reserve suggested clarifications
                  and technical changes, which GAO incorporated throughout this report, as
                  appropriate.




                  Page 10                        GAO/GGD/NSIAD-97-168 International Financial Crises
Page 11   GAO/GGD/NSIAD-97-168 International Financial Crises
Contents



Executive Summary                                                                                       2


Chapter 1                                                                                              16
                         Background                                                                    16
Introduction             Mexico’s 1994-95 Crisis Threatened the Collapse of Its Public                 20
                           Finances and Banking System and Caused Contagion
                         Mexico’s 1994-95 Financial Crisis Led to U.S. and Multilateral                22
                           Financial Assistance
                         Financial Assistance to Mexico Was Controversial                              23
                         Objectives, Scope, and Methodology                                            26
                         Agency Comments                                                               28

Chapter 2                                                                                              29
                         Sovereign Financial Crises Followed by Contagion and Systemic                 30
Mechanisms That            Risk Cannot Be Ruled Out
Help Anticipate,         Various Mechanisms Can Help Anticipate, Avoid, and Resolve                    37
                           Sovereign Financial Crises
Avoid, and Resolve       Mechanisms That Can Help Anticipate and Avoid Sovereign                       45
Sovereign Financial        Financial Crises Have Limitations
Crises Have              Mechanisms That Can Help Contain and Resolve Sovereign                        52
                           Financial Crises Have Limitations
Limitations
Chapter 3                                                                                              57
                         IMF’s Voluntary Data Standards Might Help Improve Country                     57
Initiatives Could Help      Data, but IMF Cannot Ensure Compliance
Strengthen Crisis        Initiatives to Improve Financial Stability in Emerging Market                 61
                            Countries May Not Achieve Timely Results
Anticipation and         Improving IMF Surveillance of Key Emerging Market Countries                   63
Avoidance, but              May Face Obstacles
Obstacles to Success
Exist




                         Page 12                       GAO/GGD/NSIAD-97-168 International Financial Crises
                      Contents




Chapter 4                                                                                          67
                      Initiatives Are Under Way to Improve the Provision of Official               68
Most Resolution          Financial Assistance
Improvement           Bankruptcy-Based Proposals Might Reduce Public Financing                     83
                         Costs, but They Could Operate Too Slowly to Limit Contagion
Approaches Might
Reduce U.S. Burden,
but Many May Not
Help Stem Contagion
Appendixes            Appendix I: Our Conceptual Framework for Analyzing Initiatives               94
                        and Proposals to Resolve Sovereign Financial Crises
                      Appendix II: IMF’s Special Data Dissemination Standard                       96
                      Appendix III: Comments From the Department of the Treasury                   98
                      Appendix IV: Comments From the Board of Governors of the                     99
                        Federal Reserve System
                      Appendix V: Major Contributors to This Report                               100

Table                 Table 4.1: Proposed NAB Participation                                        73


Figures               Figure 2.1: Net Private Capital Inflows to Emerging Market                   32
                        Countries (1990-96)
                      Figure 2.2: Net Portfolio Investment and Foreign Direct                      35
                        Investment in Emerging Market Countries (1990-96)
                      Figure 4.1: Participant Credit Commitments Under the General                 70
                        Arrangements to Borrow
                      Figure 4.2: Participant Shares Under the General Arrangements to             71
                        Borrow
                      Figure 4.3: Participant Credit Commitments Under the Proposed                74
                        New Arrangements to Borrow
                      Figure 4.4: Participant Shares Under the Proposed New                        75
                        Arrangements to Borrow




                      Page 13                      GAO/GGD/NSIAD-97-168 International Financial Crises
Contents




Abbreviations

BIS        Bank for International Settlements
ESF        Exchange Stabilization Fund
GAB        General Arrangements to Borrow
G-7        Group of Seven
G-10       Group of Ten
IMF        International Monetary Fund
NAB        New Arrangements to Borrow
SDR        Special Drawing Rights


Page 14                      GAO/GGD/NSIAD-97-168 International Financial Crises
Page 15   GAO/GGD/NSIAD-97-168 International Financial Crises
Chapter 1

Introduction


                              Mexico’s financial crisis of 1994-95 prompted Group of Seven (G-7) country1
                              initiatives2 to improve existing mechanisms to anticipate, avoid, and
                              resolve sovereign financial crises as well as proposals to create new
                              mechanisms. This report responds to the request of the Chairman of the
                              House Committee on Banking and Financial Services that we review and
                              evaluate these improvement initiatives and proposals. The Chairman also
                              requested that we review various aspects of Mexico’s financial crisis. We
                              provided the results of our review of the Mexico crisis in an earlier report3
                              that focused on the origins of the financial crisis; the awareness of U.S.
                              government and International Monetary Fund (IMF)4 officials of Mexico’s
                              situation during 1994; and the financial assistance package provided by the
                              United States, IMF, and others to help resolve the crisis.



Background

The International Financial   The international financial system brings international lenders of funds, in
System Connects Lenders       their own country or other countries, into contact with
to Borrowers in Different     borrowers—thereby permitting an increased flow of scarce funds toward
                              their most productive uses. This system, which is dominated by central
Countries                     banks, government agencies, the largest commercial and investment
                              banks, security and foreign exchange dealers, and major brokerage
                              houses, has grown enormously in the 1990s. Global foreign exchange




                              1
                               The G-7 consists of seven major industrialized countries that consult on general economic and
                              financial matters. The seven countries are: Canada, France, Germany, Italy, Japan, the United
                              Kingdom, and the United States.
                              2
                                The initiatives were the product of the 1995 G-7 economic summit in Halifax, Nova Scotia, and were
                              discussed in the communique issued at that meeting.
                              3
                               Mexico’s Financial Crisis: Origins, Awareness, Assistance, and Initial Efforts to Recover
                              (GAO/GGD-96-56, Feb. 23, 1996).
                              4
                               IMF is an organization of 181 member countries that was established to promote international
                              monetary cooperation, promote exchange rate stability, and provide short-term lending to member
                              countries that experience balance-of-payments difficulties. A country with a balance-of-payments
                              deficit experiences an excess demand for foreign currencies, i.e., an excess supply of its own currency.
                              In such cases, countries do not take in enough foreign currency to pay for what they buy from other
                              countries. Absent central bank intervention, the country’s exchange rate will depreciate in value.



                              Page 16                                   GAO/GGD/NSIAD-97-168 International Financial Crises
                                  Chapter 1
                                  Introduction




                                  trading—fueled by floating foreign exchange rates5 and the expansion of
                                  world commerce—now exceeds $1 trillion a day.6

                                  Many of the larger and more economically advanced developing countries,
                                  often called “emerging market” countries,7 which in the past did not
                                  participate much in the international financial system, have become
                                  important players in the last decade. Private capital flows to developing
                                  countries increased by more than threefold between 1990 and 1996, rising
                                  from $60.1 billion to about $193.6 billion, according to IMF. These
                                  countries’ entry into the global financial system has been fueled by
                                  technological advances that make investment across national borders
                                  easier, financial deregulation and economic liberalization, and other
                                  factors.


Sovereign Financial Crises:       Developing countries have benefited from their increased access to world
Causes and Effects                capital markets. Nonetheless, financial crises in developing countries still
                                  have occurred. For purposes of this report, the term “sovereign financial
                                  crisis” refers to a state of affairs in a country characterized by the
                                  following:

                              •   the inability or unwillingness of a country to honor its debt obligations and
                              •   the loss of confidence in that country’s capital and other markets, which
                                  can happen when the country does not honor its debts, expressed by the
                                  flight of capital from the country and a general unwillingness of new
                                  investors to invest in the country.

                                  According to a financial risk rating firm, 70 countries defaulted on various
                                  kinds of debt between 1975 and 1995; in 1995 alone, 36 countries were in
                                  default on some of their debts. All of these countries were either
                                  developing countries or countries that were part of the Soviet Union or
                                  Soviet-dominated Eastern Europe.

                                  Sovereign financial crises have had a variety of causes and effects. As we
                                  learned in our review of Mexico’s 1994-95 financial crisis, many such crises
                                  have had complex economic, financial, and political origins, including

                                  5
                                   Under a floating exchange rate system, the value of a country’s currency in relation to other
                                  currencies changes in response to market supply and demand for the currencies, rather than at a rate
                                  set by that government.
                                  6
                                    International Capital Movements and Foreign Exchange Markets, Group of Ten (Rome, Italy:
                                  Apr. 1993).
                                  7
                                   “Emerging markets” or “developing countries” are usually those countries whose production sector is
                                  dominated by agriculture and mineral resources and countries that are in the process of building up
                                  industrial capacity. In this report, we use these two terms interchangeably.


                                  Page 17                                  GAO/GGD/NSIAD-97-168 International Financial Crises
                            Chapter 1
                            Introduction




                            events inside of the country, outside of the country, or both. Internal
                            events that have contributed to sovereign financial crises have included
                            the adoption of macroeconomic policies that are inconsistent with
                            exchange rates, and political shocks, such as assassinations in Mexico in
                            1994. External contributing events have included loss of the confidence of
                            investors from other countries; rising interest rates in other countries,
                            such as occurred in the early 1980s; and sudden increases in petroleum
                            prices, which happened in the 1970s.

                            Sovereign financial crises can harm both the indebted country and its
                            creditors. If a country in financial crisis has debt-servicing problems,
                            creditors who hold the country’s debt must wait longer than they
                            anticipated to get paid and may not get paid the full value of their
                            investments. A country undergoing a financial crisis may experience
                            severe inflation, recession, a rise in unemployment, and other harm. Also,
                            a sovereign financial crisis can lead to substantial harm to a country
                            beyond the short term because the crisis can impair the country’s access
                            to international capital markets for years after the immediate crisis is
                            resolved.


The Contagion Effect: The   The effects of a sovereign financial crisis largely may be limited to the
Spread of One Country’s     country in which it arose and to the country’s creditors. For example,
Financial Crisis to Other   Venezuela’s financial crisis in 1995 did not have financial effects on other
                            countries’ finances, according to international financial experts.8 However,
Countries                   some crises have affected other countries’ financial situations through a
                            “contagion effect.” Contagion has occurred when investors, who could be
                            domestic or foreign, have removed their funds from other countries, or
                            reduced their new lending to them, in response to a sovereign financial
                            crisis in another country. Contagion from Mexico’s 1994-95 financial crisis
                            had a negative impact on the finances of Brazil, Argentina, and other
                            countries. It can be difficult to predict whether, and to what extent,
                            contagion will occur in a sovereign financial crisis and how prolonged the
                            contagion will be. Delay by public authorities in acting to contain a
                            sovereign financial crisis’ contagion may or may not have long-term
                            consequences on the countries that are affected by the contagion.




                            8
                             This may have been in part because, according to one financial risk rating firm, Venezuela, in 1995,
                            defaulted only on local currency-denominated debt held by Venezuelans, while it continued to service
                            its foreign-currency-denominated debts.



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                           Chapter 1
                           Introduction




Systemic Risk to the       Some sovereign financial crises may have threatened the stability of the
International Financial    international financial system. This “systemic risk” is the risk that a
System                     disturbance in financial markets, which triggers substantial unanticipated
                           changes in the prices of financial assets, might seriously harm the financial
                           position of financial firms, which could in turn threaten to disrupt the
                           payments system9 and the capacity of the international financial system to
                           allocate capital.

                           For example, collapsing asset prices might lead to the financial failure of
                           one or more of the large securities firms that hold the assets. Because of
                           the interrelationships among large financial companies, this initial
                           financial failure might lead to further failures by other securities firms and
                           commercial banks. A series of such failures by banks and other financial
                           firms might disrupt the flow of payments in the settlement of financial
                           transactions throughout the world. Such a breakdown in international
                           capital markets might disrupt the process of saving and investing,
                           undermine the long-term confidence of private investors, and disrupt the
                           normal course of international economic transactions. Department of the
                           Treasury officials told us that systemic risk can also arise—even if there
                           were no disruptions of the payments system—if a financial, economic, or
                           political shock were to lead to a sharp curtailment of the willingness to
                           extend credit to a large number of countries despite their having relatively
                           strong economic policies and performance.

                           The precise extent to which the international financial system is
                           vulnerable to this systemic risk is subject to debate. Furthermore, it can be
                           difficult to predict the degree of systemic risk to the international financial
                           system that would result from a particular sovereign financial crisis.


Moral Hazard: Altered      Investors may alter their investment decisions and countries may change
Incentives for Investors   their economic policies if they expect assistance from international
and Borrowing Countries    financial institutions or other governments. This is often called “moral
                           hazard.” Investors may believe that the risks of investing in a particular
                           country or group of countries are lowered if they expect that, at times of
                           sovereign financial crisis, official assistance will be forthcoming and
                           sufficient to guarantee their expected investment return. Debtor countries
                           may be more willing to have unsustainable financial and economic policies
                           if they expect they can get financial assistance without severe
                           consequences at some later date.

                           9
                            Broadly, the payments system is the financial system that creates the means for transferring money
                           between suppliers and users of funds, usually by exchanging debits or credits among financial
                           institutions.



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                          Chapter 1
                          Introduction




Decisions to Act May      Countries with financial problems may seek financial assistance from IMF
Balance Concerns About    or other countries. Those asked to provide financial assistance may
Systemic Risk and Moral   consider the trade-off between (1) systemic risk, i.e., the extent to which
                          the financial problems of an individual country are a threat to the
Hazard                    international financial system and (2) moral hazard, i.e., the impact of any
                          assistance provided on the future behavior of countries and investors. To
                          the extent that systemic risk is judged to be small, IMF or other official
                          sector organizations may decide that the country and its creditors should
                          be left to work out a solution on their own. To the extent that the official
                          sector judges that the threat of systemic risk is great, they may provide
                          assistance to safeguard the international financial system. Those who
                          would provide financial assistance may also consider the extent to which a
                          decision to provide assistance to a country experiencing financial
                          difficulties could influence the future behavior of both debtor countries
                          and investors. These judgments are difficult ones given that the extent to
                          which both systemic risk and moral hazard are present in any particular
                          set of financial circumstances is uncertain.


                          Mexico’s financial crisis of 1994-95, which was a result of the interplay of
Mexico’s 1994-95          complex financial, economic, and political factors, threatened the collapse
Crisis Threatened the     of Mexico’s public finances and banking system. The 1994-95 crisis spread
Collapse of Its Public    to other emerging market countries, thereby negatively affecting the
                          financial stability of those countries. At the beginning of 1994, which was a
Finances and Banking      presidential election year in Mexico, Mexico was experiencing a boom in
System and Caused         foreign investment—much of it equity and debt portfolio investments10
                          that could be withdrawn quickly. However, investor confidence in
Contagion                 Mexican debt and equity securities was shaken throughout 1994 by
                          political events, including the March 1994 assassination of the leading
                          Mexican presidential candidate. Also, U.S. interest rates began to rise,
                          which made Mexican debt securities relatively less attractive to investors.

                          To continue to attract foreign investment, the Mexican government could
                          have raised interest rates, reduced government expenditures, or devalued
                          the peso. However, raising interest rates and reducing government
                          spending were politically unattractive approaches in 1994, and devaluing
                          the peso would have altered agreements among government, labor, and


                          10
                            Portfolio investments are assets held in the form of marketable equity and debt securities. Portfolio
                          investment, in contrast to direct investment, tends to be more liquid in nature and is more likely to be
                          short term. However, this is not to suggest that selling pressures on a currency are more likely to arise
                          or to be more severe in the presence of substantial foreign portfolio investment. Historically,
                          market-forced devaluations have occurred even when portfolio investment has been almost
                          nonexistent.



                          Page 20                                   GAO/GGD/NSIAD-97-168 International Financial Crises
Chapter 1
Introduction




business and would have hurt foreign investors. Rather than adopt any of
these options, the Mexican government, in the spring of 1994, increased
issuance of short-term, dollar-linked bonds, called tesobonos. The
short-term maturity of tesobonos enabled holders of the bonds to choose
not to roll them over11 if they perceived either an increased risk of a
Mexican government debt-servicing problem or higher returns elsewhere.
Many tesobono purchasers were portfolio investors who were sensitive to
changes in interest rates and risks.

Following the August 1994 election, foreign investment flows did not
recover to the extent expected by the Mexican government. Foreign
exchange reserves held by Mexico’s central bank, which amounted to
about $29 billion in February 1994, fell to $12.5 billion in the beginning of
December 1994, with Mexican tesobono obligations of nearly $30 billion
maturing in 1995. On December 20, 1994, Mexico devalued the peso. The
discrepancy between (1) the Mexican government’s long-standing pledge
not to devalue the peso and (2) the sudden devaluation, absent an
announcement of appropriate accompanying economic policy measures,
contributed to a sharp, sudden loss of investor confidence in the newly
elected government and a growing fear that a Mexican government default
was likely in 1995. Investor confidence collapsed as investors sold
Mexican equity and debt securities, and foreign currency reserves at the
Bank of Mexico were insufficient to meet the demand of investors seeking
to convert pesos to U.S. dollars. The peso devaluation precipitated a crisis
that continued into 1995.

Early in Mexico’s crisis, financial markets in a number of emerging market
economies were affected by Mexico’s problems as investors began to limit
capital flows to these countries. According to a later analysis by IMF,
portfolio investment flows to emerging markets declined dramatically in
the first quarter of 1995. Also, risk premiums on developing countries’
bonds increased, equity prices in emerging markets fell sharply, and
currency pressures were felt, at least temporarily, in a geographically
dispersed group of economies, which ranged from Argentina and Brazil to
Hong Kong and South Africa. In our report on Mexico’s crisis, we noted
that stock markets in Argentina and Brazil were especially hard hit by
contagion, and that no new international equities were issued in six major
emerging market countries in the first quarter of 1995.




11
  We use the term “roll over” here to mean repurchase of tesobonos when the tesobonos held by the
investor matured.



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                          Chapter 1
                          Introduction




                          Citing risk of contagion and the threat to U.S. interests of a prolonged
Mexico’s 1994-95          Mexican recession, among other concerns, U.S. and IMF officials
Financial Crisis Led to   orchestrated a large financial assistance package to Mexico. The
U.S. and Multilateral     assistance package consisted of up to $48.8 billion from the United States,
                          Canada, IMF, and the Bank for International Settlements (BIS).12 The
Financial Assistance      primary goal of the assistance package was to enable Mexico to overcome
                          its short-term liquidity crisis, and thereby to prevent Mexico’s financial
                          collapse, and to prevent the further spread of the crisis to other emerging
                          market countries. U.S. officials also were concerned that Mexico’s crisis
                          could escalate into a prolonged and severe economic downturn that would
                          damage U.S. interests, including trade, employment, and immigration. U.S.
                          officials—who said that they viewed Mexico as a paradigm for countries
                          striving toward a free market economy—also believed that if Mexico’s
                          difficulties spread to other emerging market countries, the global trend
                          toward market-oriented reform and democratization could have halted or
                          even reversed.

                          The assistance provided by the United States and IMF was large in amount
                          and quickly provided. On January 31, 1995, which was less than 6 weeks
                          after Mexico’s financial crisis began, President Clinton announced that
                          Treasury’s Exchange Stabilization Fund (ESF)13 and the Federal Reserve’s
                          swap network would be used to provide up to $20 billion to Mexico.14 Both
                          sources of funds could be activated without additional legislation15 by
                          Congress.16 The next day, February 1, 1995, IMF approved an 18-month
                          standby arrangement for Mexico of up to $17.8 billion. IMF’s quick approval

                          12
                           BIS is an organization of central banks that is based in Basle, Switzerland. It is the principal forum for
                          consultation, cooperation, and information exchange among central bankers.
                          13
                            ESF is a currency reserve fund under the control of the Secretary of the Treasury that is employed to
                          stabilize the dollar and foreign exchange markets. ESF holds foreign currencies, such as the Japanese
                          yen and German mark, as well as U.S. dollars and Special Drawing Rights (SDR). SDRs are units of
                          account issued by IMF to supplement gold and currency reserves. The value of special drawing rights
                          fluctuates relative to five major currencies. In the past, ESF has been used to buy and sell foreign
                          currencies, extend short-term swaps to foreign countries, and guarantee obligations of foreign
                          governments. ESF use must be consistent with U.S. obligations in IMF regarding orderly exchange
                          arrangements and a stable system of exchange rates.
                          14
                           An initial proposal by the President on January 12, 1995, for up to $40 billion in loan guarantees to
                          Mexico from the United States failed to gain sufficient congressional support. These funds would have
                          come from a congressional appropriation specifically for that purpose, in contrast to the Treasury and
                          Federal Reserve funds that were used to assist Mexico.
                          15
                           Subsequently, in the spring of 1995, the Mexican Debt Disclosure Act was passed, requiring the
                          President to submit a report before any funds under this program could be extended.
                          16
                           Some Members of Congress questioned the administration’s authority to use ESF to assist Mexico
                          without congressional approval. In our report on the Mexican crisis, we found no basis to disagree
                          with the administration’s position that the Secretary of the Treasury, with the President’s approval,
                          had the requisite authority to use ESF in this manner.



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                          Chapter 1
                          Introduction




                          of this arrangement was unusual, considering that arrangements for IMF
                          financial assistance to indebted countries typically required months of
                          detailed negotiations among IMF, the country, and the country’s creditors.
                          Although the U.S. and IMF portion of the assistance package totaled almost
                          $38 billion, Mexico eventually used about $13.5 billion of the U.S. funds
                          and about $13 billion of the IMF funds. Mexico has repaid all of the funds it
                          borrowed from the United States.

                          IMF’s contribution to the assistance package was the largest financing
                          package ever approved for an IMF member country, both in terms of the
                          amount and the overall percentage of a member’s subscription quota.17
                          About 688 percent of Mexico’s subscription quota was provided over 18
                          months (under ordinary circumstances, the usual cumulative limit is 300
                          percent). The United States’ contribution of $13.5 billion represented
                          about 51 percent of the total assistance package used.

                          The financial assistance helped to arrest the crisis and restore financial
                          market confidence in Mexico. Although Mexico’s economy went into a
                          recession as a result of the crisis, the contagion to other countries ceased
                          and most of the affected countries recovered from the contagion within a
                          few months. In the spring of 1995, Mexico regained access to international
                          capital markets.


                          Some observers argued that the United States should not have provided
Financial Assistance      financial assistance to Mexico, often citing one or more of the following
to Mexico Was             reasons: (1) the threat Mexico’s crisis posed to other countries was
Controversial             insufficient to justify the assistance; (2) the assistance would
                          inappropriately shield investors and countries from the consequences of
                          their financial decisions and thereby increase moral hazard; and (3) the
                          threat posed to U.S. trade, employment, and immigration interests was
                          insufficient to justify the assistance.


Extent of Threat to the   Some critics of U.S. financial assistance to Mexico argued that the effects
International Financial   of Mexico’s crisis on other countries did not justify risking up to
System Was in Dispute     $20 billion of U.S. funds or the large amount of IMF funds. The critics said


                          17
                           As a condition of membership, each IMF member is required to contribute to the general resources of
                          IMF. These contributions are referred to as that member’s subscription quota and determine the voting
                          power of each member. Members usually pay up to 25 percent of their subscription quota in SDRs or a
                          convertible currency and the other 75 percent or more in the member’s domestic currency. The United
                          States’ quota, about $36 billion, is the largest in IMF and constitutes about 18 percent of the total
                          quotas.



                          Page 23                                 GAO/GGD/NSIAD-97-168 International Financial Crises
                         Chapter 1
                         Introduction




                         that the contagion effect was either (1) a temporary market overcorrection
                         that would have reversed itself before seriously harming U.S. investors or
                         other emerging markets or (2) an appropriate market correction of
                         overinvestment in these markets. One study, by an association of
                         commercial banks, investment banks, and other financial institutions,
                         argued that the Mexican crisis’ contagion was mostly ephemeral because
                         some affected countries were able to borrow in international capital
                         markets within 6 months after the crisis.18 Investment flows to emerging
                         market countries—including some hardest hit by the contagion—have
                         been large in the 2 years since Mexico’s crisis. Some analysts also argued
                         that the diversity of the holders of Mexico’s debt in 1994-95, as well as the
                         diversification of investment and loan portfolios, meant that the crisis did
                         not pose a systemic threat to the international financial system because it
                         did not threaten the health of any large, creditor country financial
                         institutions.

                         Proponents of the assistance to Mexico argued that the contagion effects
                         of the crisis were short lived, at least partly, because of the stabilizing
                         effect of the multilateral financial assistance to Mexico (i.e., the assistance
                         stopped the contagion from deepening or spreading). Furthermore,
                         Treasury officials told us that they believed that Mexico’s 1994-95 crisis
                         would have threatened the stability of the international financial system
                         had it endured because, in their view, other major emerging market
                         countries would have lost access to world capital markets for an extended
                         time.


Effect on Moral Hazard   Some opponents of the U.S. financial assistance to Mexico have argued
Was Controversial        that the assistance has created substantial moral hazard for debtor
                         countries as well as investors in those countries. The opponents have said
                         that providing the Mexican government with the foreign currency it
                         needed to redeem matured tesobonos exacerbated moral hazard for
                         investors in emerging market countries by protecting tesobono holders
                         from losses on those bonds.19 Some observers have also argued that moral
                         hazard may have contributed to Mexico’s 1994-95 financial crisis (i.e.,
                         earlier assistance to Mexico had encouraged Mexican officials to pursue a
                         mix of risky macroeconomic and financial policies and encouraged


                         18
                           Resolving Sovereign Financial Crises, Institute of International Finance, Inc. (Sept. 1996).
                         19
                          Holders of tesobonos, along with other investors in Mexico, may have experienced financial losses
                         on other investments in Mexico as a result of the crisis, including losses on equity investments in
                         Mexico’s stock market. Mexico’s stock market dropped by two-thirds (68 percent) in dollar terms
                         between December 19, 1994, and March 9, 1995.



                         Page 24                                    GAO/GGD/NSIAD-97-168 International Financial Crises
                              Chapter 1
                              Introduction




                              investors to purchase large amounts of tesobonos and inadequately
                              monitor the risks of these and other portfolio investments in Mexico).20

                              According to our analysis, these assertions could be countered with three
                              arguments. First, administration officials said that the 1995 U.S. and IMF
                              assistance was conditioned upon Mexico’s adhering to strict economic,
                              financial, and reporting requirements. These conditions may have helped
                              to mitigate any increased moral hazard for Mexico and other debtor
                              countries. These officials also noted that the assistance did not prevent the
                              crisis from causing a severe recession in Mexico. Mexico’s severe
                              recession could underscore for Mexico and other countries the negative
                              consequences of risky financial policies. Second, some financial analysts
                              have asserted that moral hazard existed, to some extent, before Mexico’s
                              recent crisis and that it will continue to exist no matter what policymakers
                              do or say. The analysts said that both investors and debtor countries will
                              continue to consider in their borrowing and lending decisions the
                              availability of financing from IMF as well as financing from major creditor
                              country governments with an interest in the financial stability of the
                              debtor country. Third, investors and debtor countries may interpret the
                              controversy surrounding the decision to assist Mexico as evidence that
                              such action is unlikely to be repeated. Officials within the administration
                              and some Members of Congress disagreed about assisting Mexico.
                              Furthermore, officials representing the U.S. government disagreed with
                              officials from other major IMF member country governments. In May 1996,
                              the Group of Ten (G-10)21 governments stated that investors, including
                              bondholders, and governments should not expect the Mexican financial
                              assistance to be repeated.


The Seriousness of Threats    Some critics of the U.S. financial assistance to Mexico have also argued
to U.S. Trade, Immigration,   that the threat the crisis presented to U.S.-specific interests, such as trade,
Employment, and Other         employment, and immigration, was insufficient to justify the assistance.
                              Some critics of the assistance to Mexico argued that the potential losses in
Interests Was Debated         U.S. jobs would not have been great and that a large influx of illegal
                              immigration may not have followed if Mexico had worked out the crisis
                              without outside assistance. U.S. government officials, citing the growth in
                              the Mexican economy and the economic interdependence of the United

                              20
                               For example, in 1982 the United States, some BIS central banks, IMF, and international commercial
                              banks provided financial assistance when Mexico became unable to make loan payments to U.S. and
                              other foreign commercial banks.
                              21
                                The G-10 is made up of 11 major industrialized countries that consult on general economic and
                              financial matters. The 11 countries are: Belgium, Canada, France, Germany, Italy, Japan, the
                              Netherlands, Sweden, Switzerland, the United Kingdom, and the United States.



                              Page 25                                  GAO/GGD/NSIAD-97-168 International Financial Crises
                         Chapter 1
                         Introduction




                         States and Mexico, argued that the United States had an interest in
                         protecting trade with Mexico—which they said would limit U.S. job losses
                         stemming from the crisis—and in preventing a Mexican economic
                         collapse. Moreover, the officials said, a Mexican economic collapse would
                         have led to a surge of illegal immigration into the United States.


                         The Chairman of the House Committee on Banking and Financial Services
Objectives, Scope,       requested that we review and evaluate initiatives and proposals to improve
and Methodology          the means of anticipating and resolving financial crises. One of our
                         objectives was to identify (1) factors that may increase or decrease the
                         probability that a future sovereign financial crisis will threaten the stability
                         of the international financial system and (2) any limitations of current
                         market and governmental mechanisms for preventing and resolving
                         sovereign financial crises. Our other objective was to evaluate initiatives
                         and proposals of the G-7 and others to better (1) anticipate and avoid future
                         sovereign financial crises and (2) resolve such crises that threaten the
                         international financial system.

                         To achieve these objectives, we interviewed U.S. government and
                         international financial institution officials from Treasury, the Federal
                         Reserve, the Department of Commerce, IMF, and the World Bank.

                         We collected and analyzed documents and interviewed international
                         investors and investment experts from the following:

                     •   commercial and investment banks based in the United States,
                     •   U.S.-based emerging market bond and equity mutual funds,
                     •   professional organizations representing capital market participants,
                     •   a U.S.-based law firm that represents countries in financial distress, and
                     •   international finance and economic experts at universities and private
                         research organizations.

                         We reviewed documents and interviewed officials to obtain information
                         about the following:

                     •   the investment flows to and from emerging market countries;
                     •   the history of sovereign financial crises;
                     •   the workings of the international financial system and threats to its
                         stability;
                     •   the genesis of sovereign financial crises and their effects on the finances
                         and economies of other countries;



                         Page 26                         GAO/GGD/NSIAD-97-168 International Financial Crises
    Chapter 1
    Introduction




•   the trade-off between systemic risk and altered incentives for investors
    and emerging market countries;
•   how financial markets assess the risks of investing in emerging markets,
    and how markets try to anticipate and avoid sovereign financial crises;
•   the efforts under way by governments and the international financial
    institutions to improve anticipation and avoidance of sovereign financial
    crises;
•   the current and proposed mechanisms for resolving sovereign financial
    crises; and
•   the U.S. budgetary implications of expanding the General Arrangements to
    Borrow.

    The documents that we collected and analyzed included books, articles,
    reports, and testimony. We attended several conferences dealing, in part,
    with sovereign financial crises. Finally, we used information that we had
    previously gathered for our February 1996 report on the 1994-95 Mexican
    financial crisis.

    To evaluate initiatives and proposals to better resolve future financial
    crises, we developed a conceptual framework with 10 elements. We
    received written comments on the draft framework from officials
    representing the public and private sectors and incorporated their
    comments to finalize the framework. As a part of our analysis, we sought
    to determine whether and how each initiative and proposal could

    (1)limit contagion and systemic risk to the international financial system,
    including responding to a crisis with sufficient speed and quantity of
    resources;

    (2)affect moral hazard;

    (3)induce appropriate country economic and financial policies;

    (4)address the cost-effectiveness associated with development and
    implementation;

    (5)share burdens among parties in a sovereign financial crisis;

    (6)facilitate coordination and communication among parties in a crisis;

    (7)be flexible enough to deal with various types of financial crises;




    Page 27                        GAO/GGD/NSIAD-97-168 International Financial Crises
                  Chapter 1
                  Introduction




                  (8)apply principles consistently to countries in similar financial distress;

                  (9)address the legal requirements needed for development and
                  implementation; and

                  (10)apportion the administrative burden of development and
                  implementation.

                  We did not use the conceptual framework to endorse or reject any
                  particular initiative or proposal. Appendix I provides more detail on how
                  we developed the framework. We conducted our work between
                  March 1996 and March 1997 in accordance with generally accepted
                  government auditing standards.


                  We obtained written comments on a draft of this report from Treasury and
Agency Comments   the Federal Reserve. Comment letters are reproduced in appendixes III
                  and IV. Both agencies generally said the report is constructive and a
                  reasonably comprehensive analysis of these issues. In addition, both
                  Treasury and the Federal Reserve provided suggestions for clarifications
                  and technical changes. Treasury’s clarifications and technical comments
                  included suggestions from the U.S. Executive Director’s Office at IMF. We
                  discussed Treasury’s comments with Treasury officials in a meeting on
                  May 30, 1997. We incorporated the suggestions throughout this report, as
                  appropriate.




                  Page 28                        GAO/GGD/NSIAD-97-168 International Financial Crises
Chapter 2

Mechanisms That Help Anticipate, Avoid,
and Resolve Sovereign Financial Crises
Have Limitations
              The possibility of a future sovereign financial crisis threatening the
              stability of the international financial system cannot be ruled out, and
              current mechanisms for anticipating, avoiding, and resolving sovereign
              financial crises have limitations. Some factors may have lessened the
              likelihood of such a systemic crisis, such as a recent decrease in
              potentially volatile portfolio investments in emerging market countries
              and a greater diversity in the sources of investments. Yet, other factors
              may have increased the probability of such a crisis, including continuing
              large funds flows into these countries, which may amplify the magnitude
              of individual sovereign financial crises and various trends that may
              contribute to the volatility of these funds.

              There are a variety of official and private sector mechanisms that can help
              anticipate, avoid, and resolve sovereign financial crises. Debtor country
              economic and financial policies that retain investor confidence can help
              avoid sovereign financial crises. Debtor country provision of information
              about their economic and financial situations can help anticipate and
              avoid sovereign financial crises. When investors avoid or sell
              country-related investments, this can signal a country that its policies are
              inappropriate or unsound. Economic monitoring and advisory activities by
              IMF and some major industrialized creditor countries can help emerging
              market countries adjust policies and practices that may lead to future
              problems. Major mechanisms to help resolve sovereign financial crises
              include IMF financial assistance, along with its conditions, and conventions
              for negotiations between debtor countries, the official sector, and
              commercial bank creditors.

              Mexico’s 1994-95 financial crisis and other sovereign financial crises have
              shown the limitations of mechanisms designed to help anticipate and
              avoid sovereign financial crises. Sovereign financial crises have been
              complex financial, economic, and political events that are difficult to
              anticipate, despite the various risk assessments and monitoring efforts of
              market participants, IMF, and creditor countries. When debtor countries or
              investors expect official funding to resolve a sovereign financial crisis—a
              situation known as moral hazard—they may pursue risky policies and
              risky investments. Also, weak commercial banks and lax bank supervision
              in emerging market countries can turn away investors. IMF and creditor
              country government surveillance of emerging market countries may not
              sufficiently focus on country financial policies.

              Problems have also impeded official and private sector mechanisms to
              contain and efficiently resolve sovereign financial crises when they do



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                                occur. When a country has debt-servicing problems, investors can have
                                strong incentives to sell their country-related investments even though
                                investors might be better off as a group if they continue to hold their
                                investments. Resolution may also be delayed by difficulties in organizing
                                interim funds that indebted countries sometimes need in a crisis. Some
                                smaller creditors may seek to be bought out by other creditors and delay
                                negotiations. IMF and creditor country governments may have difficulty
                                deciding whether to intervene to help resolve a sovereign financial crisis
                                as decisionmakers debate whether the crisis warrants intervention and the
                                extent to which intervention could create improper expectations about
                                how the official sector may act in the future. Finally, creditor country
                                governments and IMF can experience difficulties in providing sufficient
                                financial assistance quickly enough to arrest a crisis.


                                The possibility of contagion and systemic risk in a future sovereign
Sovereign Financial             financial crisis cannot be ruled out. Broader and stronger linkages
Crises Followed by              between international and domestic financial markets mean that crises
Contagion and                   can erupt much more quickly in today’s markets and can be far larger in
                                scope than in the past, according to the G-10. Factors that indicate a
Systemic Risk Cannot            potential for sovereign financial crises with contagion and systemic risk
Be Ruled Out                    include, among others, continuing large funds flows into emerging market
                                countries, which may amplify the magnitude of financial crises and various
                                trends that may contribute to volatility in the flow of funds. Factors that
                                may lessen the likelihood of a sovereign financial crisis leading to
                                contagion and systemic risk include, among others, recent changes in the
                                composition of investment flows to emerging market countries, a decrease
                                in potentially volatile portfolio investment funds flowing to emerging
                                market countries, decreased reliance on commercial bank lending, and a
                                greater diversity in the sources of investment.


Factors That May Increase       We identified some capital market trends in emerging market countries
the Likelihood of               that may increase the risk of sovereign financial crises that threaten the
Sovereign Financial Crises      international financial system.
Threatening the
International Financial
System

Large Funds Flows Continue to   Investors have been attracted to opportunities in the developing world.
Go to Emerging Market           Flows of capital to emerging market economies in the form of purchases
Economies


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of securities have increased greatly in size over the years, according to the
G-10. Despite the serious disruptions in early 1995 as a result of the
Mexican crisis, total net capital flows—both public and private—to
developing countries and countries in transition reached a record
$228 billion in 1995. According to the G-10, economic liberalization and
reform in the developing world have greatly increased the size and
volatility of cross-border investments. The G-10 has stated that emerging
market countries have a firmer grasp on fiscal conditions and, in many
emerging market countries, inflation is coming under control. For
example, macroeconomic reforms in the early 1990s in Latin America have
led to soaring private capital flows, according to a senior U.S. Treasury
official. Financial deregulation by country regulators has led to the
opening up of domestic financial markets, to borrowing and lending
abroad, to the development of stock markets, and to invitations to foreign
investors to participate as well as diminishing capital controls.1 Monetary
policies in many creditor countries have led to lower interest rates in
those countries, which then stimulated investors to search for higher
yields abroad.

Large funds flows into emerging market countries may amplify the
magnitude of financial crises, contagion, and any effect on the
international financial system. Total net private capital inflows to
emerging market countries increased by threefold between 1990 and 1996,
from about $60.1 billion to about $193.6 billion, with the largest increase
taking place between 1990 and 1991. (See fig. 2.1.) A Treasury official told
us that countries are more able to finance large current account2 deficits
than in the past because private capital is now much more readily
available.




1
 Capital controls are limits placed by countries on cross-border capital flows. Capital controls may
limit the types of flows that come into or out of a country as well as limit the speed at which funds can
enter or exit a country.
2
 A country’s current account measures its transactions with other countries’ transactions, services,
investment income, and other transfers.



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Figure 2.1: Net Private Capital Inflows
to Emerging Market Countries              U.S. dollars (billions)
(1990-96)
                                          250




                                          200                                                                                        194
                                                                                                                        181

                                                                                             163
                                                                    155
                                          150                                    143
                                                                                                          137




                                          100



                                                     60
                                              50




                                              0
                                                    1990            1991         1992        1993         1994         1995         1996
                                                   Year

                                                           Net capital inflows




                                          Source: IMF.




                                          Net private capital inflows include net portfolio investment, net direct
                                          investment, and other net flows, including short- and long-term trade
                                          credits, loans, currency and deposits, and other accounts receivable and
                                          payable. Net capital inflows for the years 1985-89 were about $40.6 billion,
                                          $50.4 billion, $48.7 billion, $40.1 billion, and $59.1 billion, respectively.

Mutual Fund Manager                       Emerging market mutual funds—institutional investors with a fiduciary
Constraints                               responsibility3 to shareholders—are an increasing source of funds for
                                          borrowers in emerging market economies. Fund managers are expanding
                                          their portfolios into new markets. As of September 1995, mutual funds
                                          dedicated to emerging market equities alone had about $100 billion of

                                          3
                                           Fiduciary responsibility is the responsibility to invest money wisely for the beneficiaries’ benefit.



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                                  securities in their portfolios. Because fund investment guidelines require
                                  mutual fund accounts to hold liquid or marketable assets, fund managers
                                  may immediately attempt to dispose of assets in a crisis, thus contributing
                                  to volatility in capital markets.

Elimination of Capital Controls   A trend toward the elimination of capital controls in emerging market
                                  countries is allowing investor funds to move more quickly in and out of
                                  countries. Such movement can increase the amount of funds that can be
                                  withdrawn suddenly from a country when financial problems become
                                  apparent. The capital controls that are being eliminated were imposed by
                                  individual countries and were intended to limit the kinds of funds coming
                                  out of a country and the speed with which the funds could leave a country.
                                  One concern was that the funds withdrawn quickly could put downward
                                  pressure on asset prices and have a destabilizing effect on the countries’
                                  financial markets. Despite the appeal of (1) capital controls as speed
                                  bumps to dampen inflows, (2) taxes, and (3) other measures to transform
                                  short-term volatile money into long-term secure investment, the
                                  experience with capital controls suggests that the economic distortions
                                  and macroeconomic costs induced by controls are more costly than the
                                  potential benefits, according to a senior Treasury official.

Liquidation of More Diverse       According to the G-10, emerging market country external investments are
Investments                       widening beyond debt into a whole array of assets—including domestic
                                  bank certificates of deposit, government debt denominated in local
                                  currency, and portfolio equities—none of which was significant in the
                                  1980s. In countries that allow local currency to be freely converted into
                                  foreign currency and withdrawn from the country, the financial
                                  instruments may be sold for local currency, converted to foreign currency,
                                  and transferred abroad. These activities further increase the amount of
                                  investment in a country that can be removed quickly from a country.

Bank Lines of Credit and          Banks in emerging market countries may have extensive
Liabilities                       foreign-currency-denominated international interbank lines of credit as
                                  well as large liabilities to foreign nonbanks. In times of diminishing
                                  confidence, banks may have difficulty refinancing these credit lines and
                                  liabilities, which can harm the banks’ financial positions. Foreign currency
                                  lending to domestic borrowers can add to the scale of a banking crisis
                                  when a devaluation makes it more expensive for borrowers and banks to
                                  acquire the foreign currency necessary to repay the loans. Also, maturity
                                  mismatches may take place when bank funding for long-term projects is
                                  drawn from short-term deposits.




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Factors That May Lessen      A study by an association of commercial banks, investment banks, and
the Likelihood of            other financial institutions; multinational firms; and trading companies
Sovereign Financial Crises   concluded that the risk of sustained contagion from a sovereign financial
                             crisis is small because the international financial system appears relatively
Threatening the              immune to systemic defaults by emerging market countries.4 The report
International Financial      states that severely adverse economic conditions on a global scale were
System                       required to precipitate the international bond defaults of the 1930s and the
                             Latin American debt crisis of the 1980s, and that the probability of similar
                             conditions is low in the medium term.

Changing Funds Flows         The composition of funds flows to emerging market countries has changed
                             since Mexico’s recent crisis, with a drop in portfolio investment in
                             emerging market countries. Portfolio investment in emerging market
                             countries fell sharply—from about $89.3 billion in 1993 to about
                             $44.5 billion in 1996. (See fig. 2.2.) According to some international
                             financial experts, direct investment5 tends to be more stable and less likely
                             to be withdrawn quickly. Much direct investment appears to be motivated
                             by multinational corporations’ locating production facilities in countries
                             with low labor costs. Federal Reserve officials told us that the recent
                             decrease of portfolio investments in emerging market countries may be
                             transient and not sustainable over time.




                             4
                               Resolving Sovereign Financial Crises, Institute of International Finance, Inc. (Sept. 1996). The study
                             also noted that no contagion ensued when Venezuela, the fourth largest debtor country in Latin
                             America, fell into arrears to private creditors and lost ready access to international capital markets in
                             1995.
                             5
                              Foreign direct investment implies that a person in one country has a lasting interest in and a degree of
                             influence over the management of a business enterprise in another country.



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Figure 2.2: Net Portfolio Investment
and Foreign Direct Investment in
                                       U.S. dollars (billions)
Emerging Market Countries (1990-96)
                                       100

                                                                                                                                 91
                                                                                          89
                                                                                                     84
                                        80
                                                                                                                      73
                                                                                                          69


                                        60
                                                                           53
                                                                                               50
                                                                                                                            45

                                        40
                                                             36
                                                                                34

                                                                  27

                                        20    19 19
                                                                                                                 17




                                         0
                                              1990           1991          1992           1993       1994        1995        1996
                                             Year

                                                      Net portfolio

                                                      Net foreign direct



                                       Source: IMF.




                                       Net portfolio investment for the years 1985-89 was about $5.1 billion,
                                       $1.4 billion, $5.2 billion, $1.8 billion, and $10.3 billion, respectively. Net
                                       foreign direct investment for years 1985-89 was about $8.6 billion,
                                       $8.6 billion, $12.1 billion, $17.6 billion, and $20.4 billion, respectively.

                                       The pattern of these capital flows changed in 1995, with a larger share
                                       going to those countries that had stronger economic
                                       fundamentals—including more open investment climates.6 These trends
                                       indicate that investors began to be more aware of the risks of investing in


                                       6
                                         World Debt Tables: External Finance for Developing Countries, 1996, World Bank, Volume One
                                       (Washington, D.C.).



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                                   emerging market countries than they were before Mexico’s 1994-95 crisis,
                                   according to the report.

Decreased Reliance on              Commercial bank lending to sovereign borrowers has been decreasing
Commercial Bank Lending and        relative to loans to private firms, according to several international
a Greater Diversity of Investors   financial experts. As syndicated long-term loans from banks to country
                                   governments have fallen, bonds and foreign holdings of domestic currency
                                   debt have risen, and short-term bank credits have risen along with trade.
                                   Diminished sovereign reliance on commercial bank lending means less
                                   commercial bank exposure and less of an impact on these banks if
                                   countries have difficulty servicing their debt obligations. Also, commercial
                                   bank loan portfolios in the 1990s have become more diversified and do not
                                   contain large proportions of loans to emerging market governments as
                                   they did in the 1980s, according to a commercial bank official.

More Varied Investor Base          According to the G-10 and the Institute of International Finance, emerging
                                   market debt and equity is more widely held by a more varied investor
                                   base—including insurance companies, pension funds, and mutual funds. A
                                   more diverse investor base means that any sovereign debt-servicing
                                   problem would affect a wider variety of market participants than was the
                                   case in the 1980s when commercial banks were the dominant providers of
                                   funds for developing countries. But a more diverse investment base also
                                   means that the effects of a failure of any individual creditor financial
                                   institution would be small. Thus, losses would be more easily absorbed
                                   and unserviceable debt more easily written down without threatening the
                                   health of creditor country financial institutions, as was the case in the
                                   1980s.7

                                   Given these factors, it is unclear whether the likelihood of a sovereign
                                   financial crisis in emerging market countries that leads to substantial
                                   contagion to other countries has increased or decreased. However, World
                                   Bank officials told us that the global economy in the 1990s has not been
                                   tested by the major economic or financial shocks that occurred in
                                   previous decades, such as the sudden oil price increases in the 1970s. Such
                                   shocks have contributed to past waves of sovereign financial crises.
                                   Furthermore, even in the absence of shocks to the global economy, the
                                   composition and direction of investment flows to emerging market
                                   countries and economic conditions within those countries can change,
                                   sometimes rapidly and unexpectedly, as can investor behavior in a crisis.
                                   For these reasons, we find no basis to rule out the possibility of future
                                   sovereign financial crises’ having substantial contagion effects on other

                                   7
                                    Financial Crisis Management: Four Financial Crises in the 1980s (GAO/GGD-97-96, May 1997).



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                                sovereign economies that might, in turn, threaten the stability of the
                                international financial system. Treasury officials told us that the likelihood
                                of sovereign financial crises is greater now than in the past because of
                                increased capital flows to developing countries, increased volatility of
                                those flows, and the growing ability of countries to run large current
                                account deficits because private markets will finance the deficits. They
                                also said that these factors may produce crises whose containment would
                                require more substantial official sector resources.


                                A variety of public and private sector mechanisms can help capital market
Various Mechanisms              participants anticipate, avoid, and resolve sovereign financial crises. Major
Can Help Anticipate,            mechanisms that can help anticipate and avoid such crises include the
Avoid, and Resolve              following:

Sovereign Financial         •   debtor countries’ governments can retain investor confidence by using the
Crises                          appropriate monetary, fiscal, debt management, and exchange rate
                                policies;
                            •   debtor countries’ governments can provide information about their
                                economic and financial situations;
                            •   investors’ avoiding or selling country-related financial instruments can
                                signal emerging market countries’ governments that their policies are
                                inappropriate or unsound; and
                            •   international financial institution and industrialized country governments
                                can provide economic monitoring and advisory activities to debtor
                                countries.

                                Major mechanisms to help resolve sovereign financial crises include the
                                following:

                            •   IMFand industrialized countries can provide financial assistance and
                            •   debtor countries and their creditors (either official creditors or
                                commercial bank creditors) can use existing conventions for negotiations
                                between them.


Debtor Country                  Debtor country macroeconomic, financial, and exchange rate policies that
Governments’ Policies and       attract investment and promote investor confidence are the best
Investor Behavior Can           safeguards against sovereign financial crises, according to several
                                international financial experts we interviewed. In their views, policies that
Help Avoid Sovereign            can enable a country to attract and hold portfolio investment flows are
Financial Crises                generally those policies that maintain low inflation, small or declining



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                             fiscal deficits, few restrictions on capital movements into and out of the
                             country, a prudent debt management strategy, and a flexible foreign
                             exchange system that allows the country’s authorities some
                             macroeconomic policy flexibility in the setting of interest rates. A
                             country’s ability to maintain such policies depends in part on its ability to
                             maintain domestic political support for the policies and on the strength of
                             its commercial banking system. Political stability can also influence
                             investor confidence in a country. Also, structural weaknesses in the
                             banking systems of debtor countries can seriously aggravate sovereign
                             liquidity crises, according to the G-10.

                             Investor behavior can also help in the avoidance of sovereign financial
                             crises, according to some international financial experts. Investors can
                             influence countries to adopt policies that they believe to be sound by
                             insisting on lending to countries with unsound or inappropriate policies
                             only at higher interest rates. The increase in the cost of borrowing, along
                             with the possibility that investors may stop lending funds altogether, can
                             provide the incentive for a country’s authorities to correct their policies,
                             which could help avoid a sovereign financial crisis. This investor behavior
                             and country reactions are forms of market discipline. If the authorities of
                             the country wanted to continue to borrow in international capital markets
                             without substantial risk premiums, they would have to alter those policies
                             to reassure investors. To the extent that debtor countries and investors
                             expect official sector intervention in the event of problems, this market
                             discipline can be undermined.


IMF and Creditor Country     International financial institutions, such as IMF and the governments of the
Governments Use              G-10 countries, also play a role in anticipating and avoiding financial crises

Surveillance to Help Avoid   in emerging market countries. Among international financial institutions,8
                             IMF plays a major role in monitoring country economic and financial
Financial Problems           situations. The Executive Board requires the organization to (1) conduct
                             “firm surveillance” over the exchange rate policies of member countries
                             and (2) adopt specific principles for the guidance of all members with
                             respect to those policies.9 IMF surveillance procedures include examining
                             the macroeconomic and related structural policies of individual countries,
                             assessing the consequences of individual countries’ policies for both the
                             country and the operation of the global financial system, and encouraging
                             countries to adopt policies that improve their financial and economic

                             8
                              Other international financial institutions include the World Bank and the Bank for International
                             Settlements.
                             9
                              Articles of Agreement, International Monetary Fund, Article IV, Section 3(b).



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situation as well as enhance the functioning of the international monetary
system.

IMF’sArticles of Agreement requires it to conduct a variety of surveillance
and oversight activities. The two principal activities are regular
consultations with member countries, which are known as “Article IV
consultations” because they are related to Article IV of IMF’s Articles of
Agreement, and multilateral discussions with countries’ officials to be held
twice yearly as part of IMF’s preparation of its World Economic Outlook
reports.

Article IV consultations typically involve an annual visit to the member
country by IMF staff. During that visit, the IMF staff are to confidentially
consult with the country’s officials on how effective their economic
policies have been during the previous year and what changes might be
anticipated during the coming year. The IMF staff are then to prepare a
nonpublic report on their findings, which is to be reviewed by IMF’s
Executive Board.10 The Board’s discussion of the IMF staff’s findings, with
country representatives present, is to constitute the Article IV consultation
with the member.

IMF’s World Economic Outlook reports are to be issued twice yearly. The
reports contain IMF staff economists’ analysis of global economic
developments during the near term and medium term, with separate report
chapters devoted to, among other topics, an overview of the world
economy and issues affecting both industrial and developing countries.
These reports, and the IMF staff studies that support them, are publicly
available from IMF. The reports provide the basis for multilateral economic
outlook discussions at the Group of Seven countries’ meetings.

Other tools of IMF surveillance include reviews of international capital
market developments, which are to result in annual public reports,11 and
informal Executive Board sessions on world economic and market
developments, which are held about every 6 weeks, according to an IMF
document. Under IMF policy, IMF’s Executive Board is to review the
principles and procedures that guide its surveillance every 2 years, to see
if any changes are needed. The latest such review, which covered the 2

10
 A recent IMF Executive Board decision provides for voluntary release of factual information after the
conclusion of an Article IV consultation. This release would provide information on the member
country’s economy and IMF’s assessment. IMF’s assessment is to reflect the Executive Board’s
discussion of the nonpublic staff report prepared before the Article IV consultation.
11
 International Capital Markets: Developments, Prospects, and Key Policy Issues, Takatoshi Ito and
David Folkerts-Landau, IMF (Washington, D.C.: Sept. 1996).



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                         years following Mexico’s recent crisis, was completed in early 1997,
                         according to an IMF official.

                         Some major industrialized countries also monitor the economic and
                         financial situations of debtor countries. These industrialized countries
                         analyze the economic and financial situations and policies of emerging
                         market countries in which they have substantial interests, such as trade or
                         security interests, and suggest policy changes to country officials when
                         incipient problems are detected. In the case of the United States, reports
                         from the U.S. embassy are to be sent to Treasury and the Department of
                         State in Washington, D.C. Some monitoring may take place from the
                         capitals of creditor countries or at international conferences where debtor
                         countries may describe and discuss their economic policies. Policy advice
                         to countries may be delivered in multilateral forums or in bilateral
                         meetings with the countries’ heads of state or officials from other parts of
                         the governments, such as the finance ministry or central bank.


IMF Financing Can Help   IMF  member debtor countries that cannot meet their financial obligations
Resolve Crises           and that find capital markets or sovereign lenders unwilling to provide
                         new financing, can ask IMF for financial assistance. IMF financial assistance
                         is intended to provide the country, over the short term, with sufficient
                         foreign currency to continue to service its debts, restructure its economy,
                         stabilize its currency, and maintain the necessary trade flows. As of the fall
                         of 1995, about 60 countries were receiving assistance from IMF, and about
                         20 other countries were actively negotiating with IMF for assistance. Most
                         IMF programs are in the form of loans that are not financed through quota
                         resources. Crisis resolution funding would usually be undertaken through
                         quota resources. As of May 1997, there were 34 loan arrangements and 25
                         programs funded through quota resources.

                         IMF member countries with balance-of-payments problems ordinarily are
                         allowed to withdraw,12 without policy conditions, up to 25 percent of the
                         funds that they contribute to IMF, according to IMF documents. That is,
                         countries may withdraw funds without performance criteria or phasing of
                         disbursements. Member countries that want additional IMF credit are
                         subject to these conditions. A member country that needs more than
                         25 percent of its contribution may request more funds from IMF and may
                         borrow cumulatively up to 3 times its contribution in any one year or
                         300 percent, cumulatively. IMF policy allows a country to exceed this
                         maximum level of borrowing in extraordinary or exceptional

                         12
                           Member withdrawals are purchases of SDRs or convertible currencies with their own currencies.



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circumstances. IMF determined that such extraordinary circumstances
existed when IMF made available about 688 percent of Mexico’s
contribution in 1995.13 Countries that borrow from IMF are expected to
repay the borrowed funds as soon as they resolve their payments problem.
Before IMF will agree to extend financing, the country seeking assistance
has to demonstrate how the funds will be used to solve its payments
problem, thereby providing for repayment of the funds within 3 to 5 years,
according to IMF documents.

To ensure that the member country uses the borrowed funds effectively,
IMF financing arrangements require borrowing countries to (1) undertake a
series of economic and other policy reforms—called “conditionality”—that
are intended to eradicate the source of the payments difficulty, (2) lay a
firmer foundation for economic growth, and (3) ensure that the country
will be able to repay the funds in a short period, according to IMF
documents. In some cases, these conditions are quite stringent and
politically difficult for countries to implement. Policy commitments of the
member country government are embodied in a letter of intent, which is
the outcome of policy discussions between IMF staff and the member
country government. Policy commitments embody performance criteria
focusing on budgetary and credit ceilings, reserve and debt targets, and
avoidance of restrictions on payments and transfers. Typically, countries
applying for IMF financing present IMF with a reform plan to lower the value
of their currency, encourage exports, and reduce government expenditure.
IMF Executive Directors are to determine both the sufficiency of the
reform measures and whether IMF can reasonably expect repayment.
Following the approval of IMF Executive Directors, the loan is to be
disbursed in installments—usually over 1 to 3 years—and disbursements
are tied to the borrowing member’s progress in implementing the planned
reforms. Borrowing members pay charges to cover IMF expenses and to
compensate the member whose currency it is borrowing. As of May 1996,
borrowers pay commitment fees of 0.5 to 1 percent and interest charges of
about 4 percent.

Different types of IMF financing arrangements are available to address
various balance-of-payments problems.14 IMF can provide this assistance

13
  Current rules permit an IMF member to borrow an amount equal to 100 percent of its quota per year,
with a cumulative limit of 300 percent, unless exceptional circumstances exist. IMF potential lending
to Mexico was about 688 percent of Mexico’s quota over an 18-month period or 459 percent of its
quota on an annual basis.
14
  Other facilities include the extended fund facility, which makes credit available for longer periods of
time; the systemic transformation facility for economies in transition from centrally planned to
market-based systems; the structural adjustment facility to support macroeconomic adjustments and
structural reforms in low-income countries; and other facilities.



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                           before debt-servicing problems arise. The most common arrangement,
                           which is called a “standby arrangement,” is to be provided to a member
                           country that is having trouble staying current in its foreign obligations and
                           is to be a conditional line of credit for up to 3 years that allows the country
                           to reorganize its finances. Standby arrangements typically focus on
                           macroeconomic policies, such as fiscal, monetary, and exchange rate
                           policies. If conditions are not met, access to further drawings is to be
                           interrupted. Another IMF facility makes funds available at low interest rates
                           to poor nations. Loans under this facility, which is administered separately
                           from regular IMF resources, require close cooperation with the World Bank
                           and its programs for economic development of the world’s poorest
                           nations.

                           IMF generally has not lent to a country until the country reached
                           agreements to settle debt claims of creditors in both the private and
                           official sectors; in other words, IMF has seldom “lent into arrears,”
                           according to IMF documents. However, IMF has made exceptions to this
                           policy, particularly after 1987. At that time, IMF relaxed conditions attached
                           to its own disbursements, thereby making disbursements before the
                           country had reached agreements with banks and approving adjustment
                           packages that involved less than full payment to banks. This policy change
                           was intended as a means of inducing commercial banks to conclude
                           negotiations with debtor countries. The purpose of the policy change was
                           to shift bargaining power in debt negotiations from the commercial banks
                           to debtor countries and to hasten resolution of debt crises, according to
                           IMF documents.



U.S. Initiatives and       The U.S. government has worked both directly and indirectly with debtor
Financial Assistance Can   countries to help resolve sovereign financial crises. To stabilize foreign
Help Resolve Crises        exchange markets, the United States has provided currency swaps to
                           emerging market countries through Treasury’s Exchange Stabilization
                           Fund and the Federal Reserve’s currency swap network.

                           Also, the U.S. government has two initiatives that it has used to deal in
                           general with the problem of developing country debt.15 In 1985, the United
                           States used the Baker plan to try to revive economic growth in developing
                           countries by arranging for debtors to borrow even more funds from both
                           private commercial banks and multilateral development banks. In 1989,
                           the United States, recognizing that these debtors could not fully service

                           15
                            Since each initiative was launched by a Secretary of the Treasury, the plans bear each Secretary’s last
                           name.



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                             their debts and restore growth at the same time, used the Brady plan to
                             seek permanent reductions in the debtors’ existing commercial
                             debt-servicing obligations. Under the Brady plan, Mexico’s government
                             reduced its debt-servicing burden to commercial banks by reducing its
                             stock of debt, lengthening maturity, and lowering interest payments.16
                             Creditor countries may also help resolve sovereign financial crises less
                             directly, by working within existing conventions for negotiating settlement
                             of debts.


Existing Conventions for     In some cases, developing countries have been unable to meet their
Negotiating Settlement of    financial obligations. A country with debt-servicing problems typically may
Debts Can Help Resolve       suspend payments and obtain legal representation to protect the country
                             from its creditors and to help it negotiate a settlement with those
Sovereign Financial Crises   creditors. An indebted country sometimes has lacked a clear
                             understanding of its true debt situation and its ability to pay those debts
                             and would seek assistance from IMF or a private firm employed to advise
                             the country. According to our analysis, the country’s creditors would
                             either sell the country’s debt to other investors, accepting any losses
                             incurred, or prepare for negotiations with the country by assessing the
                             country’s debt situation and its ability to pay those debts. The indebted
                             country would have multiple objectives in these negotiations, including
                             rescheduling some or all of its debts or having debts forgiven; continuing
                             the normal operation of its economy; maintaining political stability;
                             preserving an adequate level of foreign currency reserves; and hastening a
                             reestablishment of access to international capital markets, according to an
                             international legal expert. Creditors would seek to maximize the amount
                             of money they may receive by minimizing changes to the terms and
                             conditions of the debt—except for interest payments, which they would
                             usually try to increase.

                             The negotiations have often been conducted using existing conventions
                             that have evolved to help resolve actual or imminent sovereign defaults.
                             One mechanism, known as the Paris Club, has been used to facilitate
                             negotiations for bilateral official credits or debts owed to
                             governments—usually governments of industrialized countries. A second
                             mechanism, known as the London Club, has been used to facilitate
                             negotiations for debts owed to commercial banks.17

                             16
                               Mexico’s bank loans were converted into new bonds—with reduced principal or reduced interest
                             rates.
                             17
                              During the developing country debt crisis of the 1980s, the Paris and London Clubs were the principal
                             venues and forums for negotiations between debtor countries, commercial bank creditors, and the
                             official sector.



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The Paris Club is a forum established in the 1950s for the rescheduling or
refinancing of credits issued, guaranteed, or insured by creditor country
governments. Although it is not a formal institution but rather an informal
group of creditor country governments, the Paris Club operates according
to an agreed-upon set of policies and procedures. There is no international
statutory law that governs these policies and procedures. The Paris Club’s
membership has been determined on a case-by-case basis; however, its
membership always has included the G-7 countries and often has included
some of the other larger industrialized countries.

An indebted country applies to the Paris Club to negotiate the
rescheduling or refinancing of debts it cannot pay. IMF has been integrally
involved in Paris Club negotiations. Indeed, an IMF forecast showing that a
country cannot meet its debt-service obligation is a precondition of
opening a Paris Club negotiation. Furthermore, the Paris Club has required
the debtor country to conclude an agreement with IMF that specifies policy
reforms the country must make before rescheduling negotiations may
begin. Paris Club negotiations have generally taken about 6 to 8 months
but some cases have evolved into long, drawn-out negotiations. Paris Club
negotiations culminate in a nonbinding understanding that provides the
framework within which individual creditors conclude binding agreements
with the debtor. This framework is intended to ensure that no creditor
receives preferential treatment.

The London Club, which first was used in 1976, is a framework for
negotiating the rescheduling of credits extended by commercial banks to
governments, central banks, and other public sector institutions. Like the
Paris Club, the London Club is a set of conventions, rather than an
institution. The London Club has no fixed venue or secretariat but rather a
body of procedures and conventions extablished by precedents. The
participants in these negotiations vary with the commercial banks that
have extended credits and are exposed to losses. Commercial banks
participating in London Club negotiations form a steering committee of
typically 15 members, each of which represents a number of other creditor
banks. These creditor banks tend to be more numerous than the sovereign
creditors involved in Paris Club negotiations. This steering committee
makes its own forecast of the country’s ability to repay its debts and
negotiates policy changes that the country is to make as a condition of the
rescheduling. In the past, these commercial banks have relied on IMF to
monitor countries’ adherence to the policy conditionality, and the banks
have insisted on some form of IMF “seal of approval” before conducting a
restructuring. In practice, the banks, sovereign creditors, and IMF all



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                        engage in negotiations about the share and nature of debt relief each will
                        grant to the debtor country.

                        In London Club negotiations, agreements between the debtor country and
                        the commercial banks’ steering committee can be approved by banks
                        holding 90 to 95 percent of total bank exposure to loan losses. Banks on
                        the steering committee must at each stage of the agreement get approval
                        from the banks that they represent. Often, each bank is represented by its
                        own legal counsel who must scrutinize all agreements. Dissenting banks
                        and other entities are not compelled to accept the agreements, and
                        creditor banks or assignees of bank debt can sue debtor countries for
                        enforcement of the terms of the original loan agreement. Therefore,
                        dissenters can hold up the negotiation process until they are bought out by
                        the debtor or other creditors. For this reason, London Club negotiations
                        have been lengthy. For example, Poland required almost 14 years to
                        complete its London Club debt restructuring, which began in 1981.

                        Venues such as the Paris or London Clubs do not exist for renegotiating
                        bonded debt. Although defaults by sovereigns on
                        foreign-currency-denominated debt took place on a substantial scale
                        throughout the 19th century and as recently as the 1940s, since World War
                        II only a very small number of defaults by countries on
                        foreign-currency-denominated bonds have occurred although there have
                        been numerous sovereign debt-servicing problems, according to
                        international finance experts. Negotiations to resolve these arrears have
                        been handled on a case-by-case basis, usually in conjunction with
                        settlements of other types of debts, such as commercial bank loan debt.
                        During the 1930s, a wave of defaults occurred on sovereign bonds, which
                        was triggered by the Great Depression. To negotiate settlements of these
                        defaults, bondholders organized into committees. These committees, with
                        the support of the United States and other creditor country governments,
                        successfully negotiated settlements with the affected countries’
                        governments, although some of these negotiations took years to complete.


                        The effectiveness of these public and private sector mechanisms to
Mechanisms That Can     anticipate, avoid, and resolve sovereign financial crises can face various
Help Anticipate and     limitations. These limitations include (1) moral hazard, (2) inadequate
Avoid Sovereign         public provision of information by borrowing countries, (3) insufficient
                        analysis by investors of the information that countries do provide,
Financial Crises Have   (4) domestic obstacles that can prevent countries from adopting
Limitations             appropriate economic and financial policies, and (5) inadequate



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                           surveillance of countries’ economic and financial policies by IMF and
                           creditor country governments.


Distorted Incentives Can   Some of the international financial experts we spoke with said that the
Undermine Anticipation     expectation that public authorities will insulate lenders and borrowers
and Avoidance              from adverse consequences of their actions can entice investors to lend
                           and countries to borrow while inadequately monitoring their risk. This is
Mechanisms                 known as moral hazard. The presence of moral hazard in a financial
                           market can cause market discipline to deteriorate and countries to
                           prolong bad policies. If official sector intervention is expected, then
                           investors are more likely to purchase risky country debt. Moral hazard can
                           be a factor in international financial markets, especially for portfolio
                           investors, because, unlike direct investors who may build production
                           facilities in other countries, portfolio investors may not have a permanent
                           stake in the country’s financial health.


Information That           The globalization of financial markets has increased the importance of
Countries Provide to       disclosure and the public reporting of sovereign economic and financial
Investors May Be           data. A regular and timely flow of relevant economic and financial data
                           plays a critical role in helping a country’s government develop and
Inadequate                 implement sound policies. A regular flow of accurate and timely economic
                           and financial data to capital market participants seems likely to promote
                           the smooth functioning of international capital markets. One way that
                           countries improve their acceptability in capital markets is to publicly
                           provide data.18 Investors may use this information to assess the risk of
                           investing in countries and to help manage their investments. The better a
                           country is in providing accurate and timely data, the better investors will
                           be able to assess the risks of investing in the country. Some market
                           participants are not aware of all the information that is currently available
                           and do not adequately use the available information in the investment
                           analyses, according to the G-10. Better risk assessments can improve
                           investors’ abilities to identify countries with financial problems, and the
                           investors’ behavior of avoiding or selling investments in such countries
                           may encourage the authorities of those countries to make needed policy
                           corrections. In addition, IMF and other international financial institutions
                           and the governments of major creditor countries can use this information
                           for surveillance purposes.



                           18
                             In some cases, countries supply these data only to companies that specialize in assessing sovereign
                           risk, and the companies then sell their assessments to other businesses.



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                               Information problems may have contributed to Mexico’s 1994-95 financial
                               crisis. An often-noted problem in Mexico’s data reporting in 1994 involved
                               its infrequent reporting of foreign currency reserves. Specifically, before
                               the crisis, Mexico reported the foreign currency reserve holdings of its
                               central bank only three times annually. Since Mexico’s crisis, country data
                               have improved—in some cases, substantially—according to one analysis.
                               The previously mentioned 1996 study19 by an association of financial
                               companies found that, for 28 emerging market countries that received the
                               greatest share of funds flows to emerging market countries, the adequacy
                               of the data these countries supplied to markets had improved since the
                               1994-95 Mexican crisis. However, that same study found that the reporting
                               of certain data remained poor for many countries—notably for external
                               debt statistics.


Investors May Not Use          Companies that invest in emerging markets, including institutional
Available Information to       investors who invest their clients’ funds, have a stake in accurately
Monitor Risks                  estimating the risks of such investments. Nevertheless, in some cases,
                               investors appeared to disregard or ignore available information that may
                               have helped them assess the chances of a sovereign financial crisis.

                               In Mexico’s case, data on the buildup of the Mexican government’s
                               short-term, dollar-linked debt were not widely publicized by the Mexican
                               government, but were available to investors, according to numerous
                               sources. The differential between interest rates on Mexican and U.S.
                               government securities indicated that during much of 1994, financial
                               markets perceived a low likelihood of Mexico’s devaluing its currency or
                               having debt-servicing problems. Between August and October, 1994, this
                               differential narrowed, which suggests that markets believed that these
                               risks were decreasing. We know now that the risks of a sovereign financial
                               crisis were increasing during this time period. Representatives from some
                               large, private investment firms told us that, before Mexico’s crisis, their
                               firms’ risk assessment systems did not properly take into account
                               short-term capital flows and other liquidity considerations.

                               According to some international finance experts, the following factors
                               may have affected international investors’ willingness to demand better
                               and more timely information from Mexican authorities in 1994:

                           •   The increasing magnitude of funds available to managers of emerging
                               market investment funds put pressure on them to invest in countries with

                               19
                                 Resolving Sovereign Financial Crises, Institute of International Finance, Inc. (Sept. 1996).



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                            high rates of return without adequately analyzing the risks of these
                            investments.
                        •   Investors did not fully appreciate how quickly securitized investments
                            could be removed from a country and, therefore, may have
                            underestimated the importance of a regular flow of key data from Mexico.
                        •   Investors appeared to have had excessive faith in the ability of Mexico’s
                            leadership to change inadequate policies quickly.
                        •   The odds of a country’s having debt-servicing problems or defaulting on
                            any particular debt were generally low.


Countries May Face          International financial experts have cited weak domestic commercial
Domestic Obstacles to       banking systems as obstacles to policy changes that would retain investor
Attractive Policies         confidence in emerging market countries. Banks are at the center of
                            economic and financial activity in emerging market countries. A
                            well-functioning banking system is important for the effectiveness of
                            macroeconomic policies, and unstable macroeconomic environments can
                            make it difficult for banks to assess credit risk. A sound banking system is
                            one that is able to withstand adverse events and is a system in which most
                            banks are solvent and likely to remain so. Solvent banks are profitable,
                            well-managed, and well-capitalized. Even with many emerging market
                            banks free of government intervention, years of government control of
                            banks and inadequate competition left many banks unable to properly
                            evaluate credit risks in some countries, according to international banking
                            experts. The IMF Managing Director has said that the Mexican crisis
                            demonstrated that countries with weak and inefficient banking systems
                            are more vulnerable to contagion and less able to manage the effects of
                            volatile capital flows and exchange rate pressures.

                            Banking problems in emerging market economies can have serious
                            consequences for local economies and can spread to other countries,
                            according to international banking experts. In some emerging market
                            countries, structural weaknesses in the banking system and inadequate
                            supervision and regulation of commercial banks have made the countries
                            vulnerable to financial crises and have seriously aggravated such crises
                            when they did occur.

                            Since 1980, over 130 countries have experienced significant banking sector
                            problems.20 Banking crises in emerging markets have usually been more
                            severe than in industrial countries. Resolution costs or losses from

                            20
                               Banking Crises in Emerging Economies: Origins and Policy Options, Morris Goldstein and Philip
                            Turner, Bank for International Settlements (Basle, Switzerland: Oct. 1996).



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country banking crises have ranged from 3 percent of gross domestic
product21 in industrial countries to more than 25 percent of gross domestic
product in emerging market countries, according to international banking
experts.

A legal system that facilitates bank supervision and regulation is important
for healthy emerging market banking systems. The legal system must
facilitate bank seizures and the transfer of collateral behind delinquent
loans. Bank supervisors that need to curtail excessive risk-taking and limit
bank rescue costs, need the statutory authority to (1) issue and enforce
sanctions, such as cease-and-desist orders to banks; (2) specify accounting
practices; (3) and close insolvent banks.

According to a study by a G-10 Working Party,22 problems have arisen when
banks funded sizable amounts of long-term domestic lending with
short-term foreign currency borrowing in the wholesale interbank markets
of the main international financial centers. According to our analysis, this
type of bank funding could act as a major deterrent for a country to make
a needed devaluation because a devaluation, which increases the domestic
currency value of a bank’s liabilities, might threaten bank insolvency.
Decisions by the creditors of banks not to refinance such funding could
generate a banking crisis because emerging market governments may be
constrained from offering support to the banking system because the
government’s own financial position could deteriorate significantly. Such
banking problems may present emerging market governments with the
prospect of a large, public sector liability if these governments should take
on the bad debt of their banks.

Also, bank operations in emerging market countries tend to suffer from
(1) poor accounting systems; (2) lack of implementation of appropriate
loan valuation and classification practices; (3) nonadherence to the Basle
risk-weighted capital standard; (4) lack of limits on loans to bank owners
and directors and bank-related businesses; (5) lack of competition from
new entrants; (6) bank loan portfolios that are too concentrated by client
base or geographic region; (7) owners who do not share the risk to which
they expose their depositors; and (8) supervisory rules, if any, that do not
require regulators to impose remedial measures on banks as their capital
drops below specified levels, according to an international banking expert.
Once a banking system becomes fragile, the host country may feel

21
 Gross domestic product is the total value of goods and services produced in a country’s economy in a
year.
22
  The Resolution of Sovereign Liquidity Crises, Group of Ten (Basle, Switzerland: May 1996).



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                            constrained in using interest rates as an equilibrating mechanism to deal
                            with shifts in market sentiment by raising interest rates because higher
                            interest rates can harm banks by raising the number of nonperforming
                            loans on their books. A weak domestic banking system was part of the
                            reason Mexican government officials were reluctant to raise interest rates
                            to continue to attract investor flows.

                            Poor oversight of emerging market banks has also been a problem,
                            according to international banking experts. Supervisory guidelines have
                            been lax or easy to evade. Resources have been inadequate to monitor
                            banks. Lax entry standards have led to excessive expansion and
                            widespread subsequent failures. Entry standards that create competition
                            among banks have been allowed in foreign banks that are highly
                            competitive and have reduced the overall profitability of banks.
                            Supervisory authorities have not had the power to revoke bank licenses.
                            Capital adequacy ratios have not been high enough to safeguard bank
                            assets. Accounting and auditing standards have often been lax and ill
                            defined in the developing world. Accurate accounting practices have not
                            included current and complete recognition of nonperforming assets.

                            International financial experts have also cited political considerations as
                            impediments to policy changes that would retain investor confidence in
                            emerging market countries. Domestic political opposition can block policy
                            changes necessary to attract and maintain investment. Our report on
                            Mexico’s crisis found that such obstacles occurred in Mexico in 1994. Due
                            in part to an upcoming presidential election, Mexican authorities were
                            reluctant to raise interest rates, devalue the peso, or take other action that
                            could have reduced the inconsistency that had developed between
                            Mexico’s monetary and fiscal policies and its exchange rate system.


Activities of IMF and the   Mexico’s 1994-95 financial crisis revealed inadequacies in IMF’s monitoring
U.S. Government Can Be      and advisory activities and in the U.S. government’s monitoring of
Weakened by Inadequate      Mexico’s situation. Treasury and IMF officials told us that IMF did not keep
                            a close watch on developments in Mexico during the latter half of 1994,
Information                 did not see a compelling case for devaluation before December 1994, and
                            did not foresee the financial crisis that occurred after Mexico’s
                            devaluation.




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    According to an IMF official we interviewed, IMF commissioned a postcrisis
    study,23 which concluded that among the causes of the deficiencies in IMF
    surveillance of Mexico were that IMF was not monitoring countries on a
    real-time basis and IMF had become too tolerant of a falloff in the quality
    and timeliness of data provided by member countries that were no longer
    in an IMF-supported adjustment program. IMF public documents discussing
    the deficiencies of IMF surveillance of Mexico provided more details about
    the deficiencies. According to these documents, Mexican authorities’
    delays in reporting key data to IMF and reluctance in discussing policy
    issues when difficulties became apparent were key elements of the crisis.
    Furthermore, according to these documents, certain aspects of IMF’s
    “culture,” as well as IMF’s close relationships with its members, had
    contributed at times to less effective surveillance.

    A Treasury official we interviewed identified the following factors that
    may also have contributed to deficiencies in IMF’s monitoring of Mexico:

•   IMF staff tended to give Mexico “the benefit of the doubt” because Mexico
    had a highly respected economic team.
•   IMF’s Article IV consultation with Mexico took place early in 1994, which
    was before Mexico faced obvious financial problems.
•   IMF staff were not paying enough attention to private market borrowing by
    countries.
•   IMF staff doing financial market analysis were working independently from
    IMF country teams.


    The U.S. government was more aware than IMF of the deterioration of
    Mexico’s financial situation in 1994. Treasury and Federal Reserve officials
    monitored events in Mexico; by summer 1994, their analysts had
    concluded that the peso was overvalued. However, like IMF and most
    financial market participants, U.S. officials underestimated the potential of
    a large amount of outstanding tesobonos to precipitate an investor panic if
    Mexico unexpectedly devalued its currency.




    23
      In 1995, IMF commissioned a former senior IMF official to conduct a postcrisis study to determine
    why IMF did not anticipate the Mexican crisis. We were unable to obtain a copy of the study from IMF.
    However, an IMF official discussed some of the study’s conclusions with us, and some of the study’s
    findings have been discussed in various IMF publications.



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                          Once a country’s financial difficulties become acute, investors may
Mechanisms That Can       overreact, precipitating or deepening a crisis, according to international
Help Contain and          financial experts. According to some financial experts, governments and
Resolve Sovereign         IMF may have difficulty deciding whether to intervene to help resolve a
                          sovereign financial crisis because decisionmakers may disagree over
Financial Crises Have     (1) the extent of the threat a crisis poses to the international financial
Limitations               system and (2) whether such a threat warrants intervention, which may
                          create additional moral hazard. Also, after an agreement to intervene has
                          been reached, creditor country governments and IMF may find it difficult to
                          provide sufficient financial assistance quickly enough to arrest the crisis.


Investor Reactions May    Investors in liquid securities that are confronted with uncertainty have a
Precipitate or Deepen a   strong incentive to sell their securities, according to international finance
Crisis                    experts. Investors may react to news of a country’s deepening financial
                          difficulties by selling their country-related financial instruments, and thus
                          precipitate a crisis that would not have otherwise occurred or seriously
                          aggravate a crisis that already has begun. In response to adverse
                          information, individual investors in a country may face powerful
                          incentives to liquidate their investments immediately, before other
                          investors do the same and cause the country to run out of funds to repay
                          its debts. Individual investors have an incentive to sell their investments
                          even if the creditors would be better off as a group if the investors
                          continued to hold the debt of the country. This behavior may be more
                          common with portfolio investment, such as mutual and pension funds,
                          because (1) investments in emerging market country securities are usually
                          more readily sold than direct investments, such as production facilities,
                          and (2) the managers of these funds may have a fiduciary responsibility to
                          sell poorly performing assets. Other investors, upon seeing funds exit a
                          country, may interpret these funds flows as evidence that the country is in
                          serious financial trouble.24 If enough investors withdraw funds, what
                          began as a market disruption could quickly become a self-fulfilling crisis.
                          Investors’ overreaction to Mexico’s crisis may have contributed to the
                          spread of the crisis to other countries, to the extent that investors pulled
                          funds out of other countries because investors wrongly concluded that
                          these countries faced problems similar to Mexico’s, according to
                          international financial experts.




                          24
                            According to bank regulators, the likelihood of a loss of investor confidence is greater when
                          investors know that a country’s banking system is weak, and that the country may have trouble
                          tolerating prolonged financial trouble.



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Negotiations May Be           Various obstacles to expeditiously resolving a sovereign financial crisis
Troubled by a Scarcity of     may develop during the negotiations between a country that is having
Information and               debt-servicing problems and its creditors. Two such obstacles are a lack of
                              information that creditors may use to verify claims made by the debtor
Negotiating Strategies        country, which may lead to delays in negotiations, and delays in resolution
                              due to creditor holdouts.

Scarcity of Information and   Creditors of a country that is having debt-servicing problems may not have
Delaying Tactics              access to the information they need to verify the country’s financial
                              situation and to independently estimate the country’s economic ability or
                              political willingness to adopt economic reform measures that would allow
                              debts to be repaid, according to several international finance experts. In
                              the case of a sovereign default or difficulties with debt servicing, where
                              the lending is not backed by collateral, this information can be crucial in
                              helping investors to develop their negotiating positions. Furthermore,
                              when a country’s creditors have complex and conflicting claims, they may
                              not believe that it is in their interest to share key information among
                              themselves about a country’s ability to honor its debts. In addition, debtor
                              governments may be unsure of how much of a loss bondholders are
                              willing to accept. In such an environment, both a debtor country and its
                              creditors can engage in strategic bargaining, posturing, delaying tactics,
                              and other actions that could prolong negotiations to the detriment of one
                              or both sides.

                              There is evidence that efforts to resolve some past financial crisis were
                              troubled by these information-related problems. For example, in the 1930s,
                              negotiations over defaulted Latin American bonds were protracted, taking
                              over a decade to complete in some cases, according to an international
                              finance expert. This situation happened, in part, because incomplete
                              information problems led to strategic bargaining and delaying tactics.
                              Also, according to this expert, in the 1980s’ developing country debt crises,
                              creditor banks lacked key information on the financial position of debtor
                              countries, which also prolonged negotiations and harmed both the banks
                              and the debtor countries. This situation did not occur in Mexico in 1995
                              because the multilateral financial assistance package prevented Mexico
                              from defaulting on any of its debts.

Creditor Holdouts             After a country reaches agreement with the majority of its creditors, a final
                              problem can develop: a small number of creditors, seeking to maximize
                              their returns and hoping to be bought out by larger creditors, can block
                              the settlement. This occurred in the 1980s’ developing country debt crisis,
                              according to an IMF official, when a small number of banks involved in



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                          syndicated loans to developing countries held out and delayed settlements
                          that had been reached by the majority of banks involved in the loans. Most
                          bond contracts require unanimous approval of bondholders to alter the
                          bonds’ core provisions, which also creates a potential holdout problem for
                          bond debts.


Debtor Countries May Be   Another problem that can develop in capital markets involves the
Unable to Attract New     provision of new money to a country with debt-servicing problems,
Funds                     according to international financial experts. Often a country experiencing
                          a financial crisis requires new money to restructure its old debts or to
                          allow the adoption of policy changes that are necessary to aid its ability to
                          pay its debts. Yet, these investors, who are concerned about liquidity, have
                          a disincentive to providing additional funds to a country, largely because
                          they would be concerned that any new funds they supply would be
                          used—at least in part—to pay off old creditors. New funds were needed in
                          Mexico’s 1982 and 1994-95 financial crises. In 1982, commercial banks and
                          others provided new funds; in 1995, new funds came from the U.S.
                          government, IMF, and Canada.

                          Organizing the provision of new funds to an indebted country can be
                          particularly difficult in the case of bond financing, where it is necessary to
                          coordinate the actions of a large number of debt holders. Another reason it
                          can be difficult to organize the provision of new funds is that
                          bondholders—with their concern for rates of return and liquidity—are less
                          likely to see an advantage in a long-term lending relationship than are
                          banks or direct equity investors. Both the 1930s’ bond negotiations and the
                          1980s’ debt crisis were prolonged due to creditor reluctance to provide
                          new money.


Governments and IMF May   Our analysis showed that governments of creditor countries and IMF may
Have Trouble Helping to   be limited in their abilities to respond to sovereign financial crises. The
Resolve Crises            governments of leading creditor countries lack procedures for responding
                          to a crisis in an emerging market country, according to an international
                          financial expert. Policy disagreements within a country’s government or
                          between countries over whether a country’s financial crisis will lead to
                          contagion or systemic risk problems can impede the speed with which
                          creditor countries and IMF respond. Disagreements may also arise about
                          whether the threat posed by the crisis warrants intervention that may alter
                          future incentives for investors and countries. A consensus was not
                          achieved among major creditor countries that Mexico’s 1994-95 financial



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Have Limitations




crisis posed systemic risk, according to international financial experts.
Officials disagreed about whether there was a threat to banking systems in
countries other than Mexico and whether Mexico’s problems would result
in a shock to nondepository financial institutions around the world.
Creditor countries also disagreed about the risk to economic activity
around the world and the risk to the global trend toward market-oriented
reforms. The German and Japanese governments were concerned that
official assistance to emerging market countries would encourage reckless
lending and overborrowing.

Debates on the use of resources of creditor countries and IMF can also
hinder the speed of country response to sovereign financial crises. In
Mexico’s recent financial crisis, the United States’ response was slowed by
policy disagreements between the executive branch and Congress. After
an initial financial assistance package failed to receive sufficient
congressional support, the Exchange Stabilization Fund and the Federal
Reserve swap network was used to assist Mexico. Use of the Exchange
Stabilization Fund does not require the consent of Congress.

Individual countries also may find it difficult to provide the financial
resources necessary to respond to a financial crisis. The United States can
respond to some degree to sovereign financial crises with the resources of
the Exchange Stabilization Fund and the Federal Reserve swap network.
As of September 30, 1996, the Exchange Stabilization Fund had the
equivalent of $38 billion in Japanese yen, German marks, special drawing
rights, and dollars. The Federal Reserve swap network has various
reciprocal currency arrangements available to different countries. To the
extent that the resources of the Exchange Stabilization Fund are not
already being used in helping countries that are currently experiencing
financial crises, the Fund could be available for assisting additional
countries in trouble. Other potential creditor countries may not have the
legal authority or resources to provide assistance to countries
experiencing financial crises.

The ability of IMF to respond to a sovereign financial crisis is also
dependent upon its available resources. IMF’s various resources for
assisting countries in trouble may at any given time already be committed.
If this is the case, according to our analysis, IMF options would include
asking for additional funds from its members, suggesting that debtor
countries ask individual countries or other organizations for assistance, or
telling the debtor country that IMF resources are not available and that no
assistance will be forthcoming.



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Individual countries and IMF may find it even more difficult to provide the
magnitude of financial resources that would be necessary to respond to
multiple, simultaneous sovereign financial crises. Simultaneous sovereign
financial crises may be beyond the available resources of the United States
and IMF—especially if the countries in crisis are large emerging market
economies.




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Chapter 3

Initiatives Could Help Strengthen Crisis
Anticipation and Avoidance, but Obstacles
to Success Exist
                       International financial institutions and governments of the industrial
                       democracies have three principal initiatives under way to help anticipate
                       and avoid sovereign financial crises. These initiatives are market-based
                       efforts to address weaknesses in mechanisms to anticipate and avoid
                       sovereign financial crises. Our analysis indicated that, while these
                       initiatives appear to have the potential to contribute to helping countries
                       and their creditors anticipate and avoid some future sovereign financial
                       crises, significant obstacles could hinder their full effectiveness.

                       One G-7 initiative is IMF’s effort to promote the provision of more reliable
                       and complete information for investors and others by borrowing
                       countries. IMF developed a voluntary standard that countries may use in
                       disclosing economic and financial data to the public. IMF has said that it
                       expects countries that subscribe to the standard will comply with its
                       requirements, and has stated its intention that IMF will remove
                       nonadhering countries from the list of subscribing countries. However, no
                       ready means exist to monitor countries’ adherence to the standard.

                       A second initiative, which was put forward by a G-10 Working Party and, at
                       the time of our review was in an early stage of development, is aimed at
                       strengthening the supervision and regulation of commercial banks in
                       developing countries. This effort, if successful, would help those countries
                       overcome weak commercial banking systems, which is a major obstacle
                       they can face in adopting and maintaining policies that attract investors.
                       However, the initiative may take much time for a variety of reasons,
                       including reported entrenched domestic opposition in some developing
                       countries. A third G-7 initiative is aimed at improving IMF’s surveillance of
                       member countries’ economic and financial situations and policies. This
                       initiative may also face a number of obstacles, most notably IMF’s lack of
                       leverage over countries that are not receiving IMF funds.


                       One factor that has been cited as contributing to Mexico’s 1994-95
IMF’s Voluntary Data   financial crisis was Mexico’s inadequate public disclosure of key economic
Standards Might Help   and financial data. In 1995, IMF officials began considering what role IMF
Improve Country        might play in improving countries’ provision of such data. IMF’s ability to
                       encourage better data disclosure by countries was limited because,
Data, but IMF Cannot   according to IMF, it had no authority under its charter to require member
Ensure Compliance      countries to publish economic or financial data. Nevertheless, IMF’s
                       Executive Board decided in April 1995 that it was appropriate and
                       consistent with IMF’s articles of agreement for IMF to establish two
                       voluntary standards that IMF member countries could use when disclosing



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key economic and financial data to markets. IMF’s intent was that the use
of these standards would encourage dissemination of comprehensive,
timely, accessible, and reliable economic and financial statistics from
countries to financial markets.

One standard is to be called the General Data Dissemination Standard and
is intended for use by countries that are not yet active in global capital
markets—the majority of developing countries. IMF is in the process of
developing this standard and hopes to have approval from the Executive
Board by fall 1997, according to an IMF official.

The second standard, called the Special Data Dissemination Standard, is
stricter than the General Standard and is intended for use by countries
that are, or aspire to be, active in world financial markets. IMF began
allowing countries to subscribe to the Special Standard in April 1996, with
a transition period that is to end on December 31, 1998. During the
transition period, a country may subscribe to the standard even if its data
dissemination practices are not fully in compliance with the Special
Standard. This transition period is intended to give subscribing countries
time to adjust their practices to comply with the Special Standard. As of
May 21, 1997, 42 countries had subscribed to the Special Standard,
including all of the G-10 countries and a number of developing countries,
such as Argentina, Malaysia, Mexico, the Philippines, and Thailand.

The Special Standard has (and the less strict General Standard is to have,
when it is completed) four dimensions: (1) public access to the data;
(2) integrity of the data; (3) quality of the data; and (4) the actual data, in
terms of their coverage, frequency, and timeliness. The requirements for
both standards are to be identical for the first three of these dimensions.
The Special Standard prescribes—and the General Standard is to
prescribe—ready and equal public access to country data through advance
public notice of release calendars and simultaneous release of data to all
interested parties. For the integrity dimension, both standards are to
require (1) countries to identify the terms and conditions under which
official statistics are produced, (2) internal government access to the data
before release, and (3) ministerial commentary on the occasion of
statistical release. Integrity is to be further ensured by a requirement that
countries disclose information about revisions to their data and give
advance notice of major changes in methodology. For the quality
dimension, countries are to disseminate documentation on methodology
and sources used for their statistics, component details of the data,




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reconciliations with related data, and statistical frameworks that support
statistical cross-checks and provide assurance of reasonableness.

For the data dimension, the Special Standard lists 17 categories of
mandatory data that cover the four sectors of a country’s economy: the
real, fiscal, financial, and external sectors.1 For each data category, the
Special Standard specifies how often the country is to report the data and
how timely the reporting must be (the permitted lag). For example, one
type of data that must be reported for the external sector is a country’s
international currency reserve levels. The Special Standard specifies that a
country must report its gross official international currency reserves,
denominated in U.S. dollars, on a monthly basis with no more than a
1-week lag. Appendix II of this report shows all of the Special Standard’s
17 data categories and their reporting requirements. These reporting
requirements are more rigorous than those planned for the General
Standard.

IMF does not plan to publish the country data. Instead, IMF has established
a data dissemination electronic bulletin board on the Internet that displays
information about the IMF data standards and individual countries’ data,
and that explains how interested parties may obtain the data.2 For 7 of the
42 subscribing countries, the descriptions of the data on IMF’s bulletin
board are linked electronically to the data themselves, which are
maintained by the country. IMF plans eventually to link its electronic
bulletin board to all subscribing countries’ data.

Capital market participants and other experts with whom we spoke
generally praised IMF’s efforts to create standards for countries’ provision
of data to the public. An official from an association of commercial and
investment banks and other financial institutions told us that he believed
IMF’s standards will improve the flow of key information to financial
markets. IMF’s data dissemination standards appear to be a market-based
effort to address a specific problem in capital markets that can interfere
with markets’ ability to anticipate and avoid sovereign financial crises.




1
 The IMF Special Standard encourages, but does not require, that data be reported in two other
categories: population and forward-looking indicators, such as qualitative business surveys.
2
 The bulletin board’s Internet address is http://dsbb.imf.org.



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                              to Success Exist




IMF Is to Rely on Financial   IMF publications state that IMF expects countries that subscribe to the
Markets to Monitor and        standards to comply with them. Furthermore, IMF’s data dissemination
Enforce Adherence to the      standards electronic bulletin board informs users that, after the Special
                              Standard’s transition period ends at the end of 1998, IMF will remove
Data Standards                countries from the list of subscribing nations if IMF finds serious and
                              persistent noncompliance.3

                              However, citing both resource constraints and a lack of authority to
                              require member countries to publish data, an IMF official said that IMF does
                              not plan to (1) verify the data that countries publish under the data
                              dissemination standards or be responsible for the data’s accuracy or
                              (2) regularly monitor countries’ compliance with the data standards.
                              Instead, IMF plans to rely on financial market participants to monitor
                              countries’ compliance with the data standards. According to the IMF
                              official, when market participants have concerns about countries’
                              compliance, IMF will expect them first to bring their concerns to the
                              attention of the authorities of the country in question. However, IMF
                              officials do plan to monitor the data to some extent because IMF staff plan
                              to use the data that the countries publish for a variety of purposes and, in
                              doing so, may detect discrepancies. Also, IMF officials said that IMF will
                              devote some attention to observance of the data dissemination standards
                              as a part of its official surveillance of member countries’ economic and
                              financial policies and also during its annual Article IV country
                              consultations.

                              Furthermore, IMF officials have stated that IMF will rely primarily on capital
                              market participants to enforce compliance with its data standards. This
                              enforcement is to occur through the process of market discipline, whereby
                              market participants would remove or threaten to remove funds from a
                              country if they suspect it is not providing accurate, timely data to markets
                              and, thus, would induce the country to comply.


Financial Market              Market discipline exercised by capital market participants may help
Participants May Not Help     enforce adherence to IMF’s data dissemination standards to some extent. In
Monitor Standards             some cases, individual investors may become suspicious of a country’s
                              data quality, and remove some or all of their funds from the country. This
                              act might discipline the country to improve its data by signaling other
                              market participants to question the data and remove their funds from the
                              country, as well. However, the ability of market discipline to anticipate

                              3
                               At the time of our review, IMF had not determined the process by which IMF would decide to
                              disqualify a member country from the Special Standard. IMF plans to determine this process by the
                              end of the transition period.



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                         and avoid sovereign financial crises has varied in the past, as Mexico’s
                         1994-95 financial crisis demonstrated.

                         Furthermore, we were told that financial market participants will not be
                         able to monitor, or be willing to help IMF enforce, IMF’s data standards to
                         the extent that IMF hopes. Financial market participants can be expected
                         sometimes to inform IMF when they have compliance concerns, especially
                         in cases where the market participants have raised their concerns with
                         officials from the country in question and have not received a satisfactory
                         response. Increased contacts between IMF officials and capital market
                         participants could facilitate IMF’s learning about these events. However,
                         many financial market participants with whom we spoke said (1) that
                         market participants, for the most part, do not intend to monitor countries’
                         compliance with IMF’s data standards and (2) that they generally do not
                         expect to keep IMF informed of any compliance concerns they may have.
                         Moreover, to the extent that individual capital market participants
                         perceive that knowing a country’s published data are inaccurate might
                         give them a competitive advantage over other market participants, the
                         participants may have a disincentive to inform IMF of their compliance
                         concerns.

                         Moreover, IMF does not have a system in place to collect and assess market
                         participants’ concerns over countries’ compliance with the Special
                         Standard. IMF’s data dissemination standards Internet site encourages
                         users to comment on the standards initiative, but the site does not solicit
                         users’ concerns about countries’ compliance with the standards.


                         Following Mexico’s crisis of 1994-95, a G-10 Working Party concluded that
Initiatives to Improve   the financial systems in emerging market economies—especially the
Financial Stability in   banking sector—should be strengthened to reduce the risk they might
Emerging Market          pose in the event of a sovereign liquidity crisis. More attention needs to be
                         paid to incipient problems in the banking sector, the G-10 said. According
Countries May Not        to a Treasury official, strong bank supervisory regimes are essential to
Achieve Timely           avoiding sovereign financial crises. This official said that emerging market
                         banking systems need to have ownership distributed widely, to be free
Results                  from credit control and credit allocation guidelines, and to be open to
                         foreign banks. He said the best approach is to address underlying
                         weaknesses by ensuring a sound incentive and ownership structure,
                         developing human resources, requiring banks to hold adequate
                         risk-weighted capital, maintaining good accounting standards, and
                         establishing an effective system of bank supervision.



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                         In response to an initiative at the Lyon, France, summit in June 1996,
                         representatives of the G-10 countries and of some emerging market
                         economies have sought to develop a strategy for fostering financial
                         stability in countries experiencing rapid economic growth and undergoing
                         substantial changes in their financial system.4 A G-10 document that lays
                         out the Working Party’s strategy5 states that countries have incentives to
                         work toward robust financial systems because such a system increases
                         access to global financial markets and provides benefits in the form of
                         more stable and often faster economic growth. The document points out
                         that the ultimate responsibility for policies to strengthen financial systems
                         lies with national governments and financial authorities in the countries
                         concerned and that the role of the international community is to provide
                         advice, incentives, and a yardstick against which progress can be
                         measured. The document acknowledges that the discussion is general in
                         nature and that specific priorities and time frames in any given country or
                         group of countries will often differ. The document also states that legal
                         and judicial reforms will take longer to achieve than revising capital
                         adequacy requirements. The four components of the strategy are:

                     •   the development of an international consensus by G-10 and emerging
                         market country representatives on the key elements of a sound financial
                         and regulatory system;
                     •   the formulation of norms, principles, and practices by international
                         groupings of national authorities;
                     •   the use of market discipline and market access channels to provide
                         incentives for adoption of sound supervisory systems, better corporate
                         governance, and other key elements of a robust financial system; and
                     •   the promotion by multilateral institutions, such as IMF, the World Bank,
                         and regional development banks, of the adoption and implementation of
                         sound principles and practices.


Obstacles Exist to       A recent G-10 report found that progress in upgrading banking supervision
Improving Emerging       has not yet been widespread or substantial enough for the banking system
Market Banking           to serve as an ally to financial stability and sustainable economic growth
                         in emerging market countries. Critics of supervision improvement efforts
Supervision              have contended that international organizations lack knowledge of

                         4
                          Representatives of Argentina, France, Germany, Hong Kong, Indonesia, Japan, Korea, Mexico, the
                         Netherlands, Poland, Singapore, Sweden, Thailand, the United Kingdom, and the United States
                         participated in developing this strategy.
                         5
                          Financial Stability in Emerging Market Countries: A Strategy for the Formulation, Adoption and
                         Implementation of Sound Principles and Practices to Strengthen Financial Systems, Group of Ten
                         (Apr. 1997).



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                          emerging market banking systems and have no powers to enforce bank
                          regulatory standards. According to these critics, because entrenched
                          opposition domestically and considerations of competitiveness with other
                          banks and countries prevent bank supervisors in developing countries
                          from acting unilaterally, an international standard for emerging market
                          bank supervision and regulation developed by the Basle Committee for
                          Bank Supervision offers the best hope for improvements. However, many
                          years were required for completion of the Basle Committee’s effort to
                          create and gain adherence for capital adequacy standards to mitigate
                          banks’ exposure to market risks. Current initiatives to improve bank
                          supervision in emerging markets may also require considerable time.


                          At the June 1995 summit held in Halifax, Nova Scotia, the G-7 governments
Improving IMF             recommended that IMF improve its surveillance. A background document
Surveillance of Key       prepared for the Halifax summit recommended that IMF:
Emerging Market
                      •   devote greater resources and attention to those countries of global
Countries May Face        significance, including both industrial and emerging market countries;
Obstacles             •   devote more attention, in general, to financial and banking sector
                          developments and, in particular, to the pattern of capital flows and their
                          maturity;
                      •   offer clear and direct policy advice to all governments, especially those
                          that appear to be avoiding necessary policy measures (where IMF’s country
                          surveillance is ineffective, IMF’s managing director and/or the
                          representatives to IMF from the country in question should pass a strong
                          message to the country’s officials); and
                      •   where feasible, be more open and transparent in its assessments and
                          policy advice.

                          To carry out these recommendations, IMF is pursuing a number of changes
                          to its surveillance policies and procedures. According to an IMF official,
                          these improvements involve changes to the focus of IMF surveillance, the
                          continuity of this surveillance, the information IMF requires member
                          countries to disclose to IMF, and IMF’s “culture.” IMF plans to refocus its
                          surveillance to emphasize countries whose economic problems could have
                          a systemic impact on the world’s financial system.6 To this end, IMF has
                          created within its research department a new division that focuses on

                          6
                           An IMF official told us that IMF has not created, nor does it plan to create, a “watchlist” that identifies
                          which countries would threaten global financial stability if they encountered a financial crisis.
                          According to the official, IMF’s Executive Board was concerned about the consequences if financial
                          markets were to learn which countries were on such a list and that the existence of such a list might
                          cause IMF to focus unduly on those countries even when situations change.



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capital flows and on fast-growing emerging market countries. IMF staff are
to pay greater attention to countries’ capital accounts—especially their
debt structures and financing policies and the risks of overreliance on
easily reversible capital flows—and the soundness of their financial
sectors. To help in this, IMF analysts are to make greater use of data
generated by financial markets.

Regarding continuity in surveillance, IMF is trying to increase the frequency
and timeliness of its surveillance. An IMF official told us that the proportion
of member countries that have an Article IV consultation every 15 months
rose from 71 percent in 1993 to 77 percent in 1996. Several IMF officials
also said that surveillance between Article IV consultations has been
enhanced. They said that informal IMF staff visits to countries occur more
frequently now, especially to countries that are not receiving funds from
IMF, and that IMF now tries to send missions to countries as problems
develop, rather than waiting for the next annual Article IV cycle. Also, an
IMF official told us that there are now more frequent IMF Executive Board
meetings to review situations in particular countries. At monthly meetings,
on a rotating basis, IMF department directors brief board members on
situations in the countries under their jurisdiction. A department director
now can request a special meeting of the Executive Board to discuss a
country, as well. Finally, an IMF official told us that every 6 months staff in
IMF’s Policy Development and Review office prepare a report for the
Executive Board’s consideration that assesses the extent to which
selected member countries have implemented some of IMF’s policy
recommendations. These reports, which have included reviews of some
emerging market countries, allow the Executive Board an opportunity to
review situations in nonprogram countries in addition to those countries’
annual Article IV consultations, the IMF official said.

In addition, IMF has revised its policies on the data that countries are
required to provide IMF for surveillance purposes. In its post-Mexico crisis
review of surveillance, IMF found that, although data provision to IMF was
adequate for the majority of member countries, deficiencies existed for
many members. In September 1995, IMF’s Executive Board agreed to a set
of 12 core data categories, representing “the absolute minimum” set of
categories to be provided by all members to IMF on a regular and timely
basis for continuous surveillance.7 The categories include exchange rates,
international currency reserves, the external current account balance, and

7
 The requirements of the 12 data categories are different from, and less strict than, the requirements of
IMF’s Special Standard for publicly disclosing data. The reason for this is that all countries are
required to furnish these data to IMF, whereas the Special Standard is designed for countries that are
active in global capital markets and, therefore, could be made more demanding.



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external debt and debt service.8 IMF is in the process of defining the
appropriate coverage, periodicity, and timeliness for these data. However,
IMF anticipates that it will require that as many of the data categories as
possible be reported monthly, especially those relevant for monetary
policy, and that at times of exchange market tension, certain types of data,
such as foreign exchange reserves and foreign debt, might have to be
reported more frequently. Furthermore, IMF anticipates that, for many
countries, the list of 12 data categories will need to be supplemented with
other required data. In September 1995, IMF’s Executive Board decided that
all member countries should at least maintain their current levels of
reporting of data to IMF. According to an IMF official, all Article IV staff
appraisals now are to have a section on data quality and timeliness. This
official also said that Article IV reviews will be used as a
“consciousness-raising exercise” to encourage better transmission of data
by countries receiving IMF funds, both to IMF and to financial markets.

An IMF official told us that IMF will be less tolerant of countries in an IMF
program when these countries allow their data quality or timeliness to
deteriorate. To enforce this, IMF plans to use a graduated approach. When
members are reluctant to provide data that would allow effective
surveillance, IMF staff and management, with assistance from the country’s
representative to IMF, are to discuss the matter with the country’s
authorities. If this does not resolve the problem, the matter may be
elevated to IMF’s Executive Board. Where insufficient data provision is
caused by weak statistical infrastructures, IMF staff are to work with the
country’s officials to improve data systems and offer technical assistance,
where desirable.

IMF also has attempted to change IMF’s culture. According to both an IMF
document and an IMF official, a 1995 internal IMF study reportedly found
that IMF’s culture tended to encourage close relationships between IMF staff
and country authorities, and that IMF staff tended to give country
authorities the benefit of the doubt when they had concerns over the
country’s policies. An IMF official told us that IMF staff are now more
candid with country authorities, especially during Article IV consultations,
and that IMF staff are less likely than before Mexico’s recent crisis to give
country authorities the benefit of the doubt.




8
 The other categories are: central bank balance sheet, reserve or base money, broad money, interest
rates, consumer price index, external trade (i.e., exports/imports), fiscal balance, and gross national
product or gross domestic product.



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Some Factors May Limit        It appears that the steps IMF has taken to improve its country monitoring
IMF’s Efforts to Help Avoid   represent a conscientious effort to address weaknesses in surveillance and
Future Sovereign Financial    could improve the quality of IMF’s surveillance. If successful, these
                              initiatives might contribute to the avoidance of future sovereign financial
Crises                        crises. However, IMF’s improved surveillance and related advisory services
                              may be subject to some limiting factors already familiar to IMF. Notably, it
                              is likely that IMF will continue to have only limited influence over countries
                              that are not in an IMF program. This may be especially true for nonprogram
                              countries that are receiving large private capital inflows. Such countries,
                              as Mexico was in 1994, would not likely anticipate having to borrow funds
                              from IMF and might conclude that financial markets will continue to lend
                              them funds. Therefore, such countries could resist adopting policy
                              changes recommended by IMF. Another factor is that some sovereign
                              financial crises are the result of a complex interaction of economic,
                              financial, political, and other factors that are difficult for anyone to
                              anticipate. And, IMF’s surveillance is likely to continue to be limited by the
                              quality of IMF’s analyses of countries’ situations and policies, which in the
                              past has varied.




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Chapter 4

Most Resolution Improvement Approaches
Might Reduce U.S. Burden, but Many May
Not Help Stem Contagion
             At the time of our review, the G-7 and a G-10 Working Party had proposed
             three IMF initiatives to improve existing mechanisms to help resolve
             sovereign financial crises, and a number of proposals to create new
             mechanisms had emerged. Our analysis indicated that, if these initiatives
             are implemented, they might reduce the U.S. burden in resolving crises
             compared to the 51-percent share of the multilateral financial assistance
             provided to Mexico in 1995. However, the use of the initiatives could
             involve some trade-offs for the United States.

             The G-7 initiatives were to: (1) expand the General Arrangements to
             Borrow (GAB) lines of credit to give IMF access to more funds should they
             be needed to resolve a crisis that threatens the international financial
             system and (2) create a new, expedited decisionmaking procedure at IMF,
             called the Emergency Financing Mechanism, for use in extraordinary
             circumstances. The G-10 Working Party proposal is to change IMF’s policy to
             permit IMF to extend financing in extraordinary circumstances to an
             indebted country before the country has settled claims with its nonbank
             private creditors, as a way to encourage such settlements (such extension
             of financing is known as “lending into arrears”). During the time of our
             review, these initiatives were in various stages of development.

             The proposed expanded GAB, which is to be called the New Arrangements
             to Borrow (NAB), could reduce the U.S. share of crisis resolution funding
             compared to the proportion the United States contributed to the 1995
             assistance to Mexico. However, because the United States would
             contribute a smaller share of NAB’s resources than under GAB, U.S.
             influence in NAB might be diminished because its voting power also will
             decrease. This reduced influence might make it harder for the United
             States to obtain activation of NAB in cases where the United States believed
             activation was desirable. Similarly, the increase in the number of countries
             that would participate in decisions to activate NAB might not facilitate
             consensus decisionmaking required for the use of the funds to stem
             contagion. On the other hand, because activation of NAB would require the
             votes of countries holding a larger percentage of resources than under GAB,
             the United States would more easily be able to block activation of the new
             lines of credit. Also, although use of an expanded GAB could help minimize
             contagion effects in a sovereign financial crisis, having NAB could increase
             moral hazard for debtor countries and investors. IMF’s expedited
             decisionmaking procedures might speed IMF assistance to prevent
             contagion in a crisis and reduce pressure on the United States to act
             quickly unilaterally.




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                             An IMF lending into arrears policy for nonbank private debts might speed
                             resolution of some crises and perhaps help reduce IMF funding for crisis
                             resolution. However, this policy change could harm creditor interests in
                             future sovereign financial crises and raise the price of international capital
                             to developing countries.

                             Various improvement proposals suggested ways to encourage capital
                             markets to create mechanisms to apply principles of U.S. bankruptcy law
                             to international sovereign default, including a proposal for the
                             development of an international bankruptcy court for countries. Although
                             these proposals might eliminate or reduce public sector financing costs
                             and simplify some crisis resolution procedures, they may be difficult to
                             implement or may operate too slowly to limit contagion.


                             In May 1995, leaders of the G-7 countries recommended two initiatives to
Initiatives Are Under        improve the way the official sector can provide financial assistance to
Way to Improve the           countries that experience financial difficulties. The initiatives were to:
Provision of Official        (1) create the NAB credit lines to give IMF access to more funds should they
                             be needed to resolve a crisis that threatens the international financial
Financial Assistance         system and (2) create the Emergency Financing Mechanism for use in
                             extraordinary circumstances. In May 1996,1 a G-10 Working Party proposed
                             a change in IMF’s policy to permit IMF to extend financing in extraordinary
                             circumstances to an indebted country before the country has settled
                             claims with its nonbank private creditors, as a way to encourage such
                             settlements. IMF has implemented the emergency financing mechanism.
                             The creation of NAB awaits approval from the participating governments.
                             At the time of our review, IMF was in the process of determining whether
                             to change its lending into arrears policy.


Supplementing GAB With       One initiative by the G-7 is to increase official resources available to IMF for
NAB Would Reduce the         responding to financial emergencies or impairments of, or threats to, the
Relative U.S. Share of IMF   international monetary system. For 35 years, IMF has had GAB to help
                             ensure that IMF is able to meet urgent and potentially large demands on its
Funding to Resolve Crises,   resources.2 GAB is a borrowing arrangement3 between IMF and a group of 11
but Would Involve            industrialized countries or their central banks that allows IMF to
Trade-Offs
                             1
                              The Resolution of Sovereign Liquidity Crises, Group of Ten (May 1996).
                             2
                              GAB was originally established in 1962 out of concern for the adequacy of official resources of
                             international liquidity and the disruptive effects of short-term capital movements.
                             3
                              Treasury officials told us that both GAB and NAB are a set of contingent lines of credit and not a
                             single, comprehensive line of credit.



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(1) borrow currencies from these countries under specific conditions and
(2) lend the funds either to other GAB countries or to non-GAB IMF member
countries.4 The 11 participants of GAB are: Belgium, Canada, France,
Deutsche Bundesbank (German Central Bank), Japan, Italy, the
Netherlands, Switzerland (Swiss National Bank), Sveriges Riksbank
(Swedish Central Bank), the United Kingdom, and the United States.5 A
country receiving funds from IMF under GAB is charged a market interest
rate and pays interest quarterly. A country is required to repay the amount
of the loan within 5 years.

GAB  funds are meant to supplement ordinary IMF resources, which
amounted in 1996 to $203 billion.6 The total of GAB resources are
$23.8 billion, with an additional $2.1 billion available under a separate
agreement with Saudi Arabia.7 Under GAB, the U.S. share is about
$6.0 billion, or 25 percent, of GAB; the German Central Bank share is about
$3.3 billion, or 14 percent, of GAB; Japan’s share is about $3.0 billion, or
12.5 percent, of GAB; and the share of France and the United Kingdom is
each $2.4 billion, or 10 percent each, of GAB. Other country and central
bank shares are less.8 These contributions broadly reflect each country’s
size and role in the international economy as well as the ability of each
country to provide financing. See figure 4.1 for the credit commitments of
other countries and figure 4.2 for relative country shares.




4
 GAB can be activated to supplement IMF resources to help finance (1) conditional or unconditional
drawings by countries participating in GAB to forestall or cope with an impairment in the international
monetary system or (2) conditional drawings by nonparticipants when an exceptional situation exists
that could threaten the stability of the international monetary system.
5
 The German Central Bank, Swedish Central Bank, and Swiss National Bank are empowered by
domestic legislation to lend to IMF.
6
  This dollar figure and GAB/NAB dollar values are converted from Special Drawing Rights (SDR) at the
rate of 1.4 SDR/dollar. We took the May 30, 1997, rate of 1.3918 SDR/dollar and rounded it up to 1.4
SDR/dollar. SDR is a unit of account IMF uses to denominate all its transactions. Its value comprises a
weighted average of the value of five currencies, of which the U.S. dollar has the largest share.
7
 Saudi Arabia has an associated arrangement whereby it will lend to IMF for the same purposes and in
the same circumstances as prescribed by GAB, except in three ways. First, IMF is not authorized to
call on GAB to finance transactions with Saudi Arabia. Second, Saudi Arabia is free to accept or reject
any proposal by the IMF Managing Director. Third, GAB and the arrangements with Saudi Arabia may
be activated separately.
8
 Other GAB-participant contributions are: Italy, 6.5 percent; the Swiss National Bank, 6 percent; Canada,
5.25 percent; the Netherlands, 5 percent; Belgium, 3.5 percent; and the Swedish Central Bank,
2.25 percent.


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Figure 4.1: Participant Credit
Commitments Under the General
Arrangements to Borrow             U.S. dollars (billions)

                                    7


                                             6
                                    6



                                    5



                                    4

                                                     3.3
                                                                3
                                    3
                                                                         2.4        2.4

                                    2
                                                                                              1.5       1.4      1.3     1.2
                                    1                                                                                             0.83
                                                                                                                                         0.54


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                                  Source: IMF.




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Figure 4.2: Participant Shares Under
the General Arrangements to Borrow                                                 United States


                                                                                   German
                                                                                   Central Bank


                                                                                   Japan


                                                        14%
                                                              12.5%
                                             25%

                                                                 10%               France


                                                                10%

                                                                                   United Kingdom
                                                      28.5%




                                                                                   Other countries
                                                                                   and institutions




                                       Source: IMF.


Conditions for Activating GAB          GAB can be activated if IMF’s Executive Board and GAB participants
                                       representing three-fifths, or 60.0 percent, of the total of credit
                                       arrangements and two-thirds, or 66.6 percent, of the participants
                                       determine that the following two conditions are met: (1) the international
                                       monetary system is threatened and (2) IMF lacks sufficient resources to
                                       extend the needed financing. Individual GAB participants can opt out of GAB
                                       participation if they are having balance-of-payments problems. A GAB
                                       participant may not vote on a proposal to activate GAB to finance an IMF
                                       transaction with that participant.

                                       No formal criteria exist for determining the existence of a threat to the
                                       international monetary system. IMF officials said that the nature of threats
                                       to the international financial system changes as that system evolves. As
                                       illustrated by the controversy that arose during Mexico’s 1994-95 financial
                                       crisis, countries can disagree about the existence or extent of a potential




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                               threat to the international monetary system. With its 25-percent share of
                               GAB resources, the United States can block GAB activation if it obtains the
                               support of other GAB participants that have credit commitments large
                               enough to reach 40 percent of the total resources.

                               Over the course of the 35 years that GAB has existed, it has been activated
                               nine times to assist the United States, France, Italy, and the United
                               Kingdom. An IMF official said that GAB was activated in the 1960s and 1970s
                               both to resist and assist devaluations of these countries’ currencies. GAB
                               was last activated in 1978, when the United States drew more than $2.9
                               billion from its own reserve tranche, including $994 million in funds from
                               loans under GAB and more than $1.9 billion from IMF currency holdings.9
                               Since 1983, GAB resources have been made available to assist countries
                               that do not participate in GAB, but such use has not occurred, nor has it
                               been proposed. GAB is considered an insurance policy and is not intended
                               to be a regular source of financings, according to a U.S. Treasury official.

NAB Would Increase Official    The G-7 proposed that the G-10 and other countries increase IMF resources
Resources for IMF Resolution   through the use of the proposed NAB. NAB would increase the resources
of Financial Crises            available under the GAB credit lines to about $47.6 billion, up from the
                               current GAB level of about $23.8 billion. NAB participants would include the
                               11 countries and central banks in GAB plus the following 14 new
                               participants: 6 new European participants, 6 new Pacific Rim participants,
                               and 2 Middle Eastern countries. (See table 4.1.) The wider participation
                               under NAB reflects the changing character of the global economy and a
                               broadened willingness to share responsibility for managing the
                               international monetary system.




                               9
                                These funds were part of a package to defend the dollar, which also included funds from gold sales
                               and special financial instruments issued in foreign currencies. The General Arrangements to Borrow,
                               Michael Ainley, IMF (Washington, D.C.: 1984).



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Table 4.1: Proposed NAB Participation
                                        Geographic regions and participating countries
Participation            Europe                       Pacific Rim                 North America                Middle East
Existing GAB             German Central Bank          Japan                       United States                None
  participants           United Kingdom                                           Canada
                         France
                         Italy
                         Belgium
                         Swedish Central Bank
                         Netherlands
                         Swiss National
                            Bank
Additional               Austria                      Australia                   None                         Kuwait
 participants            Denmark                      Hong Kong                                                Saudi Arabia
 joining NAB             Finland                         Monetary
                         Luxembourg                      Authoritya
                         Norway                       Korea
                         Spain                        Malaysia
                                                      Singapore
                                                      Thailand
                                           a
                                            The Hong Kong Monetary Authority’s participation in NAB is subject to the consent of the
                                           member whose territories include Hong Kong. Hong Kong was a territory of the United Kingdom
                                           until June 30, 1997, after which Hong Kong reverted to China.

                                           Source: IMF.



                                           The anticipated amounts of credit commitments and relative shares for
                                           each of the NAB participating countries are provided in figures 4.3 and 4.4.
                                           The proposed amount for the United States is $9.4 billion, which
                                           represents slightly less than 20.0 percent of the total NAB resources. The
                                           German Central Bank and Japan each are to contribute about $5.0 billion,
                                           or 10.5 percent, of NAB. France and the United Kingdom are to each
                                           contribute $3.6 billion, or 7.6 percent, of the total.




                                           Page 73                               GAO/GGD/NSIAD-97-168 International Financial Crises
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 Figure 4.3: Participant Credit Commitments Under the Proposed New Arrangements to Borrow
  U.S. dollars (billions)
   11

  10
         9.4
   9

   8

   7

   6

                5     5
   5

   4                        3.6   3.6

   3
                                        2.5   2.5
                                                    2.2
                                                           2
   2                                                            1.8
                                                                      1.4
                                                                            1.2   1.1   0.94
   1
                                                                                               0.58 0.54 0.52 0.48 0.48 0.48 0.48 0.48 0.48 0.48 0.48

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                                                          Page 74                                   GAO/GGD/NSIAD-97-168 International Financial Crises
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Figure 4.4: Participant Shares Under
the Proposed New Arrangements to
                                                                                                      United States
Borrow

                                                                                                      German
                                                                                                      Central Bank

                                                                                                      Japan


                                                                                                      France
                                                        10.5%       10.5%

                                                                            7.6%
                                             19.7%
                                                                              7.6%                    United Kingdom




                                                            44.1%




                                                                                                      Other countries
                                                                                                      and institutions




                                       Source: IMF.




                                       NAB would not replace GAB, but it would be the facility of principal
                                       resource—that is, a proposal for assistance would first be considered
                                       under NAB; if rejected, the proposal could be made to GAB participants.10
                                       The maximum amount of funds available under NAB would be $47.6 billion.
                                       One-half of this amount, or $23.8 billion, would be available under GAB.

Conditions for Activating NAB          Under the NAB proposal, the following criteria used for NAB activation
                                       would not change from the criteria used for GAB activation: IMF Executive
                                       Board and NAB participants must concur with the IMF Managing Director’s
                                       determination of an impairment in the international monetary system and
                                       impaired IMF resources. However, activation of NAB is to require a larger


                                       10
                                          Activation to finance an IMF transaction with a G-10 country is an exception to this rule in that either
                                       GAB or NAB can be considered first.



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                              majority voting share than for GAB activation—80 percent of the total
                              credit arrangements, which is up from GAB’s 60 percent. The United States
                              can block activation if joined by any one other large participant or two
                              small participants. Under the envisioned composition of NAB participants,
                              if one large or two small NAB participants do not vote, then the United
                              States can unilaterally block NAB activation, according to Treasury
                              officials. Unlike GAB, NAB activation would not require a second majority of
                              two-thirds of the number of participants voting.

                              As with GAB, NAB resources could be used to assist either NAB participants
                              or nonparticipants. Individual countries and participating institutions
                              would be able to opt out of NAB participation if they were having
                              balance-of-payments problems. Members that did not participate for this
                              reason would lose their “vote” in decisionmaking, and the voting share of
                              the other participating members would increase. In addition to any
                              meetings needed for activation, NAB participants are to meet annually to
                              discuss macroeconomic and financial market developments that could
                              lead to requests for NAB activation. NAB would enter into force when
                              adopted by participants with credit arrangements totaling about
                              $40 billion, including the five participants with the largest credit
                              arrangements.

U.S. Participation in NAB     Congressional approval would be necessary for the increased U.S.
Would Require Congressional   resources pledged to NAB. According to established U.S. budget
Authorization and an          procedures, U.S. participation in NAB would require congressional
Appropriation                 authorization and appropriations. Because $6.0 billion of the $9.4 billion
                              needed to fund NAB have already been appropriated by Congress to fund
                              GAB, NAB funding requires an additional $3.4 billion in new appropriations.
                              A transfer of dollars to IMF would not be scored as a budgetary outlay
                              because the United States receives in return for the transfer a monetary
                              asset (i.e., a liquid, interest-bearing claim on IMF that is backed by IMF’s
                              financial position, including its holdings of gold). A senior Treasury official
                              told us that U.S. participation in NAB would not affect the size of the U.S.
                              budget deficit. That is, an exchange of monetary assets is not scored as a
                              budgetary outlay, and therefore, does not have an impact on the budget
                              deficit.

Our Analysis of NAB           In our analysis of the proposal to establish NAB, we found two significant
                              trade-offs. First, NAB could ease the relative U.S. burden of crisis resolution
                              funding through increased burden sharing among a greater number of
                              countries when IMF resources are impaired and the international monetary
                              system is at risk. Although the dollar amount of the U.S. share in NAB



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would increase, the U.S. share of the funding burden would be lower
under NAB than under GAB—about 20 percent compared with 25 percent.
Also under NAB, the proportional U.S. burden would be significantly less
than the 51-percent share that the United States contributed to the 1995
multilateral financial assistance package for Mexico. However, at the same
time, the larger number of NAB participants could dilute the influence of
the United States by decreasing its voting power. The reduced U.S. voting
share in NAB might make it more difficult for the United States to convince
others to activate NAB.

Similarly, the larger number of countries in NAB could complicate
activation, since more countries will likely have to consent to activate NAB.
Reaching a consensus among a sufficient number of countries about
whether the financial difficulties of one or more countries pose a threat to
the international monetary system might be difficult, especially given the
greater diversity of NAB membership compared to GAB membership.11 No
specific formal criteria exist for determining a threat to the international
financial system. Uncertainty about the circumstances under which NAB
will be used helps diminish moral hazard on the part of countries and
investors. As in the past under GAB, NAB participants may be more likely to
view a financial crisis in their geographic proximity as a threat to the
international monetary system than a financially troubled country that is
geographically, economically, or strategically distant from the member
country. IMF and Treasury officials told us that NAB participants who view
the world regionally are shortsighted because countries that expect help
from outside their region now must be willing to assist countries in other
regions later. To the extent that NAB can be activated by its participants,
the United States might be less likely to be called on unilaterally to provide
financial assistance to countries in financial trouble. To the extent that NAB
is difficult to activate, the United States may continue to face the difficult
choice of whether to act unilaterally to assist financially troubled
countries.

Treasury officials told us that another one of NAB’s new voting rules could
help compensate for the reduced U.S. voting power in NAB. Under NAB, the
GAB requirement that two-thirds of member countries concur in activation
is to be eliminated. According to Treasury officials, the dropping of this
requirement would offset to some extent the increased difficulty in
activating NAB that would be caused by the increase in the share of

11
  Treasury officials said that GAB was not used in the 1994-95 Mexican crisis primarily because IMF
had sufficient liquidity to supply its share of the needed funds. However, the officials also said that
some GAB participants believed that the Mexican crisis did not pose a threat to the international
financial system and, therefore, did not meet the second GAB activation criterion.



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contributions needed for activation from 60 percent under GAB to
80 percent under NAB.

Second, NAB could help minimize contagion effects of a sovereign financial
crisis because investors may have more confidence that the official sector
will have sufficient funds to prevent a specific country’s financial
difficulties from impairing the international monetary system. However,
NAB could increase moral hazard for debtor countries and investors. For
example, NAB could increase moral hazard by providing an incentive for
financial officials in debtor countries to develop ill-advised financial,
monetary, and exchange-rate policies because NAB resources would be
available to bail them out if their policies failed. Other critics have
maintained that moral hazard for investors would be increased if NAB
resources were used to shield investors in emerging market countries from
any financial losses.

Treasury officials told us that moral hazard cannot be entirely eliminated
but that it can be held to acceptable levels if official involvement in dealing
with sovereign financial crises is rare and limited to exceptional
circumstances. In the case of standing financial arrangements, such as GAB
and NAB or IMF itself, moral hazard is limited through the imposition of
features such as policy conditions and phasing of disbursements,
according to the Treasury officials.

Others have said that the structure of NAB would not create or increase
incentives for debtor countries and investors to make imprudent decisions
because there is no certainty that NAB would be activated for any particular
country or set of circumstances. Treasury officials told us that the G-7 was
careful to design NAB with built-in redundant mechanisms to minimize
moral hazard, notably, criteria that NAB shall only be used in cases of a
threat to the international monetary system and the larger, 80 percent,
majority required to activate NAB. In fact, with an 80-percent voting share
required for activation, the United States would more easily be able to
block activation of the new credit lines despite having a smaller voting
share than under GAB. Under NAB, the United States and any other large NAB
participant or two small NAB participants would have sufficient votes to
block the credit lines’ use, according to Treasury officials. Furthermore,
NAB funding may not create or increase moral hazard for countries because
IMF imposes stringent economic and financial conditions on countries,
according to a U.S. Treasury official.




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Expedited Decisionmaking    With the speed at which capital flows can be reversed, debtor countries
Could Speed IMF             can quickly find themselves considered poor credit risks and excluded
Assistance to Limit         from international capital markets. Under certain circumstances, the
                            official sector may need to act quickly to prevent the collapse of a
Contagion                   country’s finances, forestall contagion, and help minimize the time that the
                            debtor country may be excluded from capital markets. The approval of IMF
                            support, from the onset of Mexico’s crisis in 1994, took 6 weeks. This
                            experience underscored the need for earlier IMF decisions. Also, some G-10
                            members said that they were not adequately consulted in the process of
                            developing IMF assistance.

                            The G-7 recommended that IMF accelerate its decisionmaking process about
                            funding to countries experiencing a financial crisis. The IMF Executive
                            Board agreed in September 1995 to establish exceptional procedures in
                            what the Board has called an emergency financing mechanism. The new
                            procedures are limited to exceptional situations that threaten member
                            financial stability, with significant risks of contagion, and require
                            accelerated negotiations. Such situations may or may not include NAB
                            activation. According to an IMF document, it is not the purpose of the
                            emergency financing mechanism to provide guarantees of any kind against
                            sovereign default.

                            After the Executive Board agrees that extraordinary circumstances are at
                            hand and activates the emergency financing procedures, the Board is to
                            review a report describing the member country’s current economic
                            situation. The Executive Board is to be regularly briefed on negotiations
                            with the country, and key creditors are to be consulted. Rapid negotiations
                            and quick IMF decisionmaking is critically dependant on the readiness of a
                            country to take measures to deal with the crisis. A member’s past
                            cooperation with IMF is to have a strong bearing on the speed with which
                            IMF can assess the situation. When agreement between the borrowing
                            country and IMF is reached, agreement documents are to be circulated
                            within 5 days and the IMF Executive Board is to meet within 48 to 72 hours.
                            Members who overcome their crises quickly are to repay IMF on an
                            accelerated basis.


Our Analysis of Expedited   The expedited IMF decisionmaking process could help provide a speedy
IMF Decisionmaking          official response to stem contagion effects on financial markets in other
                            countries and, possibly, to forestall or mitigate international systemic risk.
                            In some crisis situations, a speedier IMF decisionmaking process could
                            reduce pressure on the United States to act quickly unilaterally. To the



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                            extent that the new emergency financing mechanism would speed official
                            resources to debtor countries in crisis, it would also be responsive to
                            criticisms that mechanisms for responding to country crises are too
                            cumbersome and slow. However, although the emergency mechanism
                            could speed funding decisions, it is not likely to lessen disagreement
                            among IMF Executive Board members and those they consult about the
                            seriousness—i.e., the extent of potential contagion or systemic risk—of
                            any particular financial crisis the Board confronts. To the extent that IMF
                            Executive Directors have difficulty reaching a consensus on whether the
                            extraordinary circumstances needed to use the emergency financing
                            mechanism are present, IMF assistance may not be quick enough to stem
                            contagion and minimize systemic risk. IMF Executive Directors have noted
                            the lack of objective criteria for advance identification of financial crises
                            requiring rapid response, according to an IMF document.

                            The moral hazard effects of an expedited IMF decisionmaking process are
                            unclear, according to our analysis. An expedited consultative and
                            decisionmaking process at IMF might heighten incentives for debtor
                            countries to seek official financing, if the possibility of a more timely
                            decision about whether or not a country would get assistance makes such
                            financing more desirable. However, the financial and economic conditions
                            that necessitate IMF assistance, as well as the conditions that follow from
                            IMF assistance, are often severe. Countries often prefer not to devalue their
                            currency, limit credit, reduce budget outlays, and increase taxes, which
                            are measures that IMF often requires as a condition of assistance. The
                            existence of an emergency financing mechanism would guarantee neither
                            IMF support nor unusual access to IMF funds, according to an IMF document.



Changes in Lending Policy   IMF officials told us that they are considering a G-10 recommendation that
Could Speed Resolution,     IMF expand its existing policy of lending, in exceptional circumstances, to
but May Harm Creditor       countries that are behind on their payments of principal and interest to
                            noncommercial bank private creditors. This policy is called lending into
Interests and Raise the     arrears. Such a policy is intended to prevent a failure to reach an
Cost of Capital             agreement with creditors from holding up implementation of IMF
                            assistance. Since 1970, IMF policy has been to provide assistance only after
                            a country has reached an agreement with private creditors on a timetable
                            for eliminating arrears. The first exception to the no-arrears policy
                            provided that arrears to official creditors would not preclude
                            disbursements under an IMF program if a Paris Club agreement covering
                            those arrears had been reached. The policy was revised in the late 1980s
                            when there was a problem of widespread arrears and IMF assistance was



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                                being delayed as some small commercial banks sought to hold up debt
                                restructuring agreements with debtor countries, with the objective of
                                being bought out by other larger banks. The policy was amended to
                                provide that arrears to private bank creditors would not preclude
                                disbursements under an IMF program if a critical mass of the arrears were
                                the subject of an agreement among the banks. According to the G-10, a
                                policy of lending into arrears may provide IMF and the official sector with
                                an opportunity to manage a crisis by signaling confidence in debtor
                                country policies.

                                As a general rule, current IMF procedures require clearance of arrears or
                                imminent clearance of arrears before IMF disbursement of financial
                                assistance. In most cases, for arrears to commercial banks, IMF will not
                                disburse funds before actual or imminent agreement on clearance of
                                arrears. For arrears to official creditors, IMF typically waits for imminent
                                agreement in the Paris Club before assisting a debtor country. However,
                                IMF policy does permit lending into arrears for debts owed to sovereign
                                creditors and commercial banks in exceptional circumstances. Therefore,
                                in situations where a debtor country is late in payments on its financial
                                commitments, and there is neither imminent agreement nor extraordinary
                                circumstances, its access to IMF assistance is blocked. This can be a
                                serious problem for countries who have no other source of financing than
                                IMF and whose economic situation is deteriorating. Lending into arrears
                                can provide financing that can jump-start a debtor country’s economy in
                                an environment where private creditors are difficult to mobilize. In some
                                cases, member countries that agree to follow a program monitored by IMF
                                will receive help in obtaining bank creditors and other loans to clear its
                                arrears. An IMF official told us that clearance of arrears takes an average of
                                3 years, with a minimum of 6 months and a maximum of 7 years.

Sharing the Burden of Country   IMF’s prohibition against lending into arrears was developed as a
Refinancing                     mechanism to ensure that all groups of creditors share the burden in
                                country refinancing, according to IMF documents. IMF has only been
                                partially successful in achieving this goal because (1) not all commercial
                                banks have contributed commensurate with debtor country needs and
                                (2) the exposure of the bilateral and official sector has grown
                                substantially. Creditor groups not willing to contribute should not be able
                                to accumulate claims that are ultimately paid out of the resources other
                                creditor groups are providing, the IMF documents stated. The abrupt
                                termination of commercial bank loans creates financing needs that the
                                official sector may not be prepared to fully meet, and that the official
                                sector may not want to be seen as bailing out banks.



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                               In May 1996, a G-10 Working Party recommended that IMF’s Executive
                               Board consider extending IMF’s lending into arrears policy to
                               noncommercial bank private debts, i.e, to permit such lending in
                               exceptional circumstances, as is the case for official debts and commercial
                               bank debts. An IMF official said that the lack of a negotiating venue or
                               group for financial instruments not held by commercial banks or the
                               governments of countries complicates negotiations to end arrears. A G-10
                               Working Party wrote that allowing IMF to lend into arrears could
                               strengthen the bargaining position of debtor countries and signal that
                               debtor country adjustment efforts are satisfactory to IMF and, thereby,
                               warranting support from creditors. Without IMF lending into arrears, policy
                               pronouncements by debtor countries concerning monetary, fiscal, and
                               exchange rate policies may have little credibility with creditors.

Our Analysis of Lending Into   Creditors strongly oppose IMF’s extending its lending into arrears policy to
Arrears                        cover noncommercial bank private debts. One association that represents
                               commercial banks, investment banks, and other financial institutions has
                               written that IMF lending into arrears is an official sector approval for a
                               breach of contract. This is because changes in IMF procedures that improve
                               the bargaining position of debtor countries may force investors to
                               renegotiate debt with diminished principal and interest payments.
                               According to the association, this runs contrary to investor expectations
                               and may increase the riskiness of bond financing and bank loans to
                               countries and their central banks. Furthermore, according to the
                               association, lending into arrears raises the risk of moral hazard on the part
                               of debtor country officials by letting them know that they may be able to
                               make principal and interest payments at rates lower than originally agreed.
                               Therefore, extending the policy to noncommercial bank private debts
                               would increase the risks to investors in emerging market countries and
                               would likely reduce the supply and raise the price of international capital
                               flows to emerging economies. Therefore, according to the association’s
                               report, extending IMF’s lending into arrears policy to noncommercial bank
                               private debts may harm creditor interests in future sovereign financial
                               crises.

                               However, such a policy could have the advantage of strengthening IMF’s
                               ability to more quickly contain and resolve sovereign financial crises,
                               which could diminish the potential for future crises to pose a risk to the
                               international financial system. Furthermore, extending IMF’s lending into
                               arrears policy in this manner could reduce moral hazard for investors.
                               Such a policy might diminish investor perceptions that in a future




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                           sovereign financial crisis, public financial assistance would fully insulate
                           them from financial losses.

                           Private creditors have an incentive to demand full payment according to
                           the original terms and condition of their bond contracts and are less
                           concerned about the impact on the debtor country or impact on the
                           international financial system. It is not certain that creditors as a group
                           would fare worse if they were pressured to settle outstanding claims with
                           a country. If such a settlement were being impeded by individual creditors’
                           delaying negotiations or holding out and blocking implementation of a
                           completed settlement, then creditors as a whole could get more of their
                           money back or get their money back more quickly were IMF to induce them
                           to complete a settlement.


                           Several proposals suggested ways to reduce the need for official sector
Bankruptcy-Based           assistance to resolve future financial crises by requiring or encouraging
Proposals Might            capital markets to create mechanisms to apply principles of U.S.
Reduce Public              bankruptcy law to international default situations. For instance, one
                           proposal suggested that an international bankruptcy court be developed.
Financing Costs, but       Other proposals suggested ways to apply specific bankruptcy principles,
They Could Operate         and we categorized these proposals into three groups: (1) giving IMF
                           authority and responsibility to apply the principles; (2) making statutory
Too Slowly to Limit        changes so that country officials and creditors would abide by the
Contagion                  principles; and (3) encouraging the private sector to develop market
                           mechanisms, such as bond covenants and bond committees, to apply the
                           principles.

                           One objective in applying principles of U.S. bankruptcy law to sovereign
                           default situations would be to resolve creditor claims without the need for
                           official sector financing. Three principles of U.S. bankruptcy law that
                           could be applied to sovereign default situations are commonly referred to
                           as the following: (1) automatic stay, (2) postpetition creditor preference,
                           and (3) “cramdown.”12 These principles are briefly described as follows:

                       •   The automatic stay principle prohibits creditors from attempting to collect
                           a debt or obligation that was incurred by the debtor within a certain time
                           before the bankruptcy petition was filed. One effect of this principle is to

                           12
                              Chapter 9 of the U.S. Bankruptcy Code, 11 U.S.C. section 901, et seq., protects municipalities against
                           creditor panics by providing a process for adjustment of the municipalities’ debts without interference
                           by the bankruptcy court in the exercise of the municipalities’ governmental powers. Chapter 11 of the
                           Code provides for the reorganization of the debtor (typically a business) as an alternative to asset
                           liquidation.



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                                  allow a company or municipality to suspend payment of its debt to
                                  creditors. Generally, the stay remains in effect until the bankruptcy court
                                  lifts it or the case is closed. The stay is a measure that is intended to
                                  protect the debtor from attempts by individual creditors to seize assets at
                                  the expense of all creditors.
                              •   The postpetition creditor preference principle allows for the extension of
                                  “administrative priority” to new loans (made after the bankruptcy
                                  proceeding has begun) so that the debtor can obtain working capital to
                                  remain in operation. Such credit generally is a first-priority administrative
                                  expense to ensure repayment of new loans ahead of any prebankruptcy
                                  loans.
                              •   The cramdown principle provides a way to prevent a minority of creditors
                                  from blocking a settlement of claims. Where a qualified majority of
                                  creditors accepts a plan for reorganizing or rescheduling debt, the
                                  bankruptcy court can approve the plan as long as it is fair and equitable
                                  with respect to dissenting creditors. This mechanism provides a way to
                                  control dissident creditors who otherwise could prevent the
                                  reorganization of the debtor or adjustment of its debts.

                                  According to some public and private sector officials, the application of
                                  these bankruptcy principles to international sovereign debt might foster
                                  investor confidence and could result in more orderly and efficient
                                  resolutions of future debt crises, without the need for official sector
                                  financing. For example, an automatic stay could provide “breathing room”
                                  to enable debtors and creditors to examine the circumstances of a crisis
                                  and determine a resolution strategy without the need for public financial
                                  assistance or the threat of multiple lawsuits and the fear of losing much
                                  return on investments. However, some public and private sector officials
                                  also believed that an underlying problem in applying these principles is
                                  that debtor nations and their creditors would have to subordinate their
                                  interests to the process used to interpret and implement these principles.
                                  As suggested by several proposals, this could be accomplished by either a
                                  judicial-type body or other neutral, competent institution or by other
                                  arrangements, such as market-based, contractual commitments. Sovereign
                                  debtors and their creditors might not be willing to do this.


International Bankruptcy          One proposal suggested that an international bankruptcy court or similar
Court Proposal Is Not Fully       formal procedure be established to apply principles of U.S. bankruptcy
Developed and Has                 law to sovereign financial crises. Such a court or procedure might help
                                  capital markets overcome the problems they sometimes have resolving
Received Mixed Appraisals         sovereign financial crises.



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                            Although some officials representing academia, nonprofit organizations,
                            and the private sector have studied several issues surrounding this
                            proposal, specific implementation details were either not available at the
                            time of our review or varied as to how to set up such a court and what
                            institution, if any, should oversee its operations. Furthermore, the
                            bankruptcy court proposal did not break out the operational costs and
                            who should provide funding for these costs.

                            To determine how such a court might be developed or operated, we
                            interviewed public and private sector experts and officials and reviewed
                            numerous reports and studies on the issue. Some officials said that such a
                            court could be modeled after the operations of existing institutions, such
                            as the International Court of Justice.13 Our review of some of the
                            International Court of Justice’s operations showed that it has experienced
                            numerous problems and has been used relatively rarely. We found no clear
                            consensus regarding which institution should act as or oversee an
                            international bankruptcy court. However, some officials suggested that IMF
                            or the World Bank could perform this function because of their universal
                            memberships and significant experience in the debt-restructuring process.
                            However, other officials questioned whether these institutions are the best
                            candidates. For example, one academic reported that IMF has not kept
                            pace with changes in the world financial system and did not do a good job
                            in leading the debt restructurings in the 1980s. Also, questions have been
                            raised about whether these institutions have adequate resources to take on
                            this responsibility and whether they could be impartial due to their alleged
                            susceptibility to political pressure from member countries. Finally,
                            officials noted that there could be challenges associated with specific
                            implementation procedures or processes, such as how a court could
                            consistently apply requirements to debtors and diverse groups of nonbank
                            creditors with different attitudes toward risk and commercial and legal
                            doctrines for debt-rescheduling.


Although an International   Proponents of developing an international bankruptcy court believed that
Bankruptcy Court May Not    such a court would not pose a substantial risk of moral hazard on the part
Pose a Moral Hazard, It     of the debtor country. The G-10 reported that bankruptcy procedures do
                            not substantially increase moral hazard on the part of the debtor country if
Also May Not Limit          they do not significantly alleviate the pain for the debtor that is associated
Contagion Effects           with insolvency. Some private sector officials we interviewed said that
                            country officials would not default on debt obligations merely because a

                            13
                             The International Court of Justice was established in 1945 as the principal judicial body of the United
                            Nations to settle disputes peacefully among member nations.



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                             court action might allow them to suspend debt payments or obtain new
                             working capital. However, some other officials said that there could be a
                             potential for moral hazard on the part of the debtor country due to the
                             difficulties of defining and measuring the insolvency of a sovereign nation
                             and distinguishing between sovereign governments that “cannot pay” from
                             those who “will not pay.”

                             Even though moral hazard might not be increased, several public and
                             private sector officials believed that an international bankruptcy court
                             may not limit contagion effects or systemic risks in a timely manner.
                             Although supporters of this proposal hold that a court could improve
                             coordination and communication among debtors and creditors during a
                             workout process and the potential for investor panics could thus be
                             reduced, the court might have difficulty responding to and resolving
                             sovereign financial crises in a timely manner. Disagreements between
                             debtors and creditors could be inevitable regarding the purpose,
                             formulation, and interpretation of bankruptcy standards and procedures.
                             Furthermore, debtor countries might use the court as a delaying tactic,
                             and creditors might sue within their own countries’ legal systems to
                             override the judgments of the court. These issues, coupled with the
                             likelihood that a court would not have sufficient power to enforce a
                             workout plan, could add even more time to crisis resolution. Timeliness
                             could be further impaired should the court get bogged down in
                             adjudicating single-country debt crises that pose only a small threat to the
                             international financial system at the expense of crises that pose a more
                             substantial systemic risk.


An International             Supporters of developing an international bankruptcy court, or a similar
Bankruptcy Court Could       formal procedure, point out that one principal advantage of such a
Reduce the Need for          mechanism is that a bankruptcy court could ensure that capital markets
                             deal with sovereign default with little or no need for official sector
Official Sector Financing,   financing. From this point of view, less official funding would be needed to
but Countries May Never      assist countries in default because debtors and creditors would be bound
Use the Court                to resolve their claims in court. Moreover, sovereign borrowers would
                             have to rely on private capital markets, and the court could help supervise
                             administrative priority to new loans to ensure that countries in financial
                             distress would be in a good position to obtain much-needed working
                             capital.

                             An international bankruptcy court might offer two other advantages. First,
                             supporters have asserted that such a court could provide structure and



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predictability for sovereign default workouts. Several academic experts in
this field have written that capital markets are not efficient in dealing with
sovereign bankruptcies due to the many complex and often competing
creditor claims, and that a court could help creditors and debtors reach
agreements. Second, some officials believe that a bankruptcy court for
countries could make the burdens of settlements more equitable. With the
protection afforded by the bankruptcy court or procedure, these officials
have argued, creditors could be made to share the burden of adjustment
more fairly with debtor countries.

Although a formal bankruptcy court or procedure for countries might yield
several advantages to the United States, the G-10 governments and officials
from other organizations have rejected the idea. A G-10 Working Party on
resolving sovereign liquidity crises concluded in its report that such
procedures do not in current circumstances or in the foreseeable future
provide a reasonable way of dealing with such crises. The report argued
that there are numerous challenges associated with a bankruptcy court’s
development, implementation, and enforcement, and that bankruptcy
principles should not necessarily be applied to international default
situations because there is a false analogy between helping bankrupt
companies and governments’ experiencing financial difficultly. However,
the report acknowledged that international sovereign bankruptcy
procedures may warrant additional study by other interested parties.

Also, critics of this proposal have questioned whether nations would
(1) be willing to give up their sovereignty and agree to an international
body of bankruptcy law or (2) surrender their financial and economic
interests to the judgment of an international bankruptcy court. According
to various legal experts, the International Court of Justice has had a
problem with this issue because, among other reasons, governments have
preferred to keep all law-creating and law-defining processes firmly within
their control. The experts questioned whether a common international law
could be developed due to the many different sets of cultural and legal
values that operate globally. As a result, the United Nations’ member
countries have infrequently used the International Court of Justice—only
about 40 disputes have been submitted to the Court during the last 47
years.14



14
  One well-known case that illustrates the reluctance of countries to use the International Court of
Justice occurred when the United States withdrew from court proceedings in the case concerning
Military and Paramilitary Activities in and against Nicaragua in January 1985. In its withdrawal notice,
the United States alleged that “the Court lacked jurisdiction and competence.”



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                                  Critics also have argued that, even if countries were willing to give up their
                                  sovereignty and use an international bankruptcy court, the effectiveness of
                                  such a court could be limited unless it had the inherent power to enforce
                                  its decisions. Moreover, they pointed out that a court might not ever be
                                  able to guide required policy changes in government operations the way a
                                  national bankruptcy court guides the reorganization plans of firms. As a
                                  result, an international bankruptcy court might only be able to serve as an
                                  advisory body, which is the same problem that has been experienced by
                                  the International Court of Justice.


Other Bankruptcy-Based            Additional proposals to reduce the need for financial assistance from the
Proposals Face                    public sector pertained to applying specific U.S. bankruptcy principles to
Implementation Challenges         international sovereign default. We categorized these proposals into three
                                  groups: (1) giving IMF authority and responsibility to apply the principles,
                                  (2) making statutory changes so that country officials and creditors would
                                  have to abide by the principles, and (3) encouraging the private sector to
                                  develop market mechanisms, such as certain bond covenants and a
                                  standing committee to represent bondholders to apply the principles.

Proposal Giving IMF the           Two proposals by international financial experts suggested ways to give
Authority to Apply Specific       IMF the authority to apply specific bankruptcy principles. One proposal
Principles Is Not Being Pursued   was for IMF to reinterpret its mandate to allow it to sanction and enforce
                                  countries’ suspension of debt payments to creditors. This proposal, in
                                  essence, would apply the automatic stay principle of the U.S. Bankruptcy
                                  Code. IMF Article VIII(2)(b) provides that IMF has some authority over
                                  exchange contracts that involve the currency of any of its members. Under
                                  this article, exchange contracts that (1) involve the currency of a member
                                  and are contrary to exchange control regulations of that member and
                                  (2) are maintained or imposed consistently with the IMF Articles of
                                  Agreement are unenforceable in the territory of members. Supporters of
                                  this proposal have argued that IMF could interpret this provision in such a
                                  way as to formally endorse the existence of a member’s arrears. According
                                  to this view, IMF could use its authority under the article to render
                                  exchange contracts unenforceable, and, in effect, sanction a standstill,
                                  thus protecting a country from its creditors. However, critics question
                                  whether IMF can legally interpret the article to give it authority to sanction
                                  a standstill. Another proposal suggested that IMF develop a mediation
                                  service to apply the cramdown principle to help debtors and creditors
                                  renegotiate debt settlements.




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                                Both of these proposals are at an early stage of development so they
                                lacked sufficient information for detailed evaluation. Furthermore, IMF
                                officials told us that they were not pursuing these proposals as viable
                                options. Although the proposals suggest interesting possible ways to help
                                resolve future crises, they might be difficult to develop. There are two
                                primary potential benefits to the first proposal. IMF (1) might be in a good
                                position to sanction an automatic stay because it has authority and
                                expertise to evaluate a country’s policies and financial needs and to judge
                                whether a stay is justified and (2) would have more control over contagion
                                effects because it could actively signal to financial markets that a
                                country’s temporary debt payment suspension is appropriate, which, in
                                turn, could assure markets that the country will pursue sound policies in
                                the future. Therefore, the country would not lose access to new capital in
                                the future. However, critics question the legal acceptability of IMF’s
                                reinterpreting its Articles of Agreement to give it authority to suspend
                                country debt payments. Several academic experts reported that the
                                articles would probably have to be amended and that doing so could be a
                                difficult, time-consuming task. These experts also noted that approval
                                would be required from one-half of IMF’s member countries with most of
                                the total voting power, and that most member countries probably would
                                resist the amendment on behalf of the rights of their investors.

                                Regarding the second proposal, IMF might be able to offer mediation
                                services similar to those offered by the World Bank’s International Center
                                for the Settlement of Investment Disputes.15 An IMF official said that this is
                                not a viable option because there are many mediation services available
                                and that mediation services are not part of IMF’s mission. Also, critics of
                                this proposal have raised questions as to whether IMF could be neutral
                                serving in a mediation capacity.

Proposal Suggesting Statutory   Another proposal suggested that the U.S. Sovereign Immunities Act be
Changes to Apply Specific       amended in a way that, in essence, would apply the cramdown principle of
Bankruptcy Principles Must      U.S. bankruptcy law to sovereign default situations. Generally speaking,
Overcome Many Challenges        the act currently allows creditors to sue a foreign state for default on its
                                debt payments where the state has waived its sovereign immunity or




                                15
                                 The International Center for the Settlement of Investment Disputes was created in 1966 to provide
                                conciliation and arbitration facilities for disputes between governments and foreign private
                                enterprises.



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                              where the suit relates to the state’s commercial activity.16 To eliminate the
                              possibility of future lawsuits, this proposal suggested that the act be
                              amended to render a foreign state immune from suit by creditors while a
                              restructuring plan was being negotiated by a majority of creditors or after
                              their acceptance of the plan.

                              Proponents of this proposal have maintained that a new legal framework
                              could facilitate workouts within the United States because the threat of
                              lawsuits or other pressures from dissenting creditors would be eliminated.
                              Also, they contended that amending the act could facilitate restructuring
                              by preventing a small minority of creditors from holding up a negotiated
                              settlement. However, critics have said that implementation of this
                              proposal faces serious obstacles because all major creditor countries
                              would have to adopt appropriate changes to produce the desired effect
                              universally. This consensus could be difficult to accomplish because
                              numerous countries have different laws, legal traditions, and legal
                              philosophies.

Certain Bond Covenants or a   Two proposals suggested ways that capital markets could establish
Permanent Bondholder          mechanisms to change conditions of debt contracts so that creditors could
Committee Could Apply         accept a reorganized repayment plan, should a country be faced with
Bankruptcy Principles         debt-servicing problems. Specifically, the proposals encouraged (1) the
                              establishment of a standing bondholder committee or committees and
                              (2) the revision of certain bond covenants. With respect to the latter
                              proposal, covenants that generally require unanimity would be revised to
                              provide that a qualified majority of creditors could make changes in the
                              payment terms and conditions of bonds, thus facilitating workouts.


Establishing Bondholder       One proposal suggested that a representative bondholder committee or
Committees                    committees be established to facilitate negotiations between bondholders
                              and debtor governments when the latter fail to pay principal or interest
                              according to the bonds’ original terms and conditions.17 Such a committee



                              16
                               The pertinent provisions of the Sovereign Immunities Act are contained at 28 U.S.C. sections
                              1602-1610. In general, the act sets forth the conditions and circumstances under which U.S. courts
                              have jurisdiction over lawsuits against foreign states, their agencies, and instrumentalities. Among
                              other things, the act allows for such lawsuits where sovereign immunity has been waived and where an
                              action relates to the foreign state’s commercial activity in the United States or outside the United
                              States (when such activity causes a direct effect in the United States).
                              17
                               “Symposium—The New Latin American Debt Regime—Towards a Sovereign Debt Work-out System,”
                              Journal of International Law and Business, Rory Macmillan (Volume 16, 1995) and Crisis? What Crisis?
                              Orderly Workouts for Sovereign Debtors, Barry Eichengreen and Richard Portes (Jan. 1996).



                              Page 90                                 GAO/GGD/NSIAD-97-168 International Financial Crises
                             Chapter 4
                             Most Resolution Improvement Approaches
                             Might Reduce U.S. Burden, but Many May
                             Not Help Stem Contagion




                             would avoid a proliferation of committees,18 resolve conflicts among
                             classes of bondholders, and appoint representatives to negotiate with
                             bankrupt governments to restructure their debts. Such a committee might
                             contain permanent and temporary members, representing large
                             bondholders, mutual funds, pension funds, and other market participants,
                             and could be modeled after similar committees, such as the London Club.
                             In addition, the proposal suggested that the governments of the major
                             creditor countries may want to recognize a single, standing international
                             bondholder committee.19 The proposal suggested a specific charter for this
                             committee that would specify the committee’s operations, a set of
                             conventions, a core of permanent members, a permanent secretariat, and
                             an appointed representative to conduct negotiations. The proposal stated
                             that, under certain conditions, IMF could play a role in helping such a
                             committee reach its goal by providing temporary liquidity during the
                             restructuring process that could be repaid as part of an agreement to a
                             final restructured payment plan.


Bondholder Committee         Criticisms of the proposal to create a bondholder committee for
Effect on Moral Hazard       international bonds include that such a mechanism would create moral
Unclear, Although Unlikely   hazard for countries that issue sovereign bonds. The critics assert that
                             creating a mechanism to specify how the bonds would be restructured
to Stem Contagion            could provide more incentive for countries to default on principal and
                             interest payments than having no mechanism at all. However, proponents
                             of bondholder committees do not concede this point. They say that the
                             consequences of debt-servicing problems for a country are so severe (e.g.,
                             possible loss of access to international capital markets) that the existence
                             of a bondholder committee would not provide an incentive for debtor
                             countries to announce that they are having debt-servicing problems.

                             Because bondholder committees have historically taken a long time to
                             reach agreement on how sovereign bonds should be restructured, the
                             committee would neither diminish contagion effects on other countries’
                             financial instruments nor forestall systemic risk to the financial system. A
                             bondholder committee may not contain contagion effects because
                             creditors could still rush for the exits. Defenders of a standing bondholder


                             18
                               In the past, multiple committees, with diluted bargaining power, negotiated with governments over
                             bond issues. These committees competed against one another for subscriptions and commissions.
                             Bondholders hesitated to subscribe to the services of a committee because they were aware that
                             competition reduced the likelihood of successful negotiations. Committee organizers had an incentive
                             to maximize their commission, rather than the return to bondholders.
                             19
                              There are historical precedents for such mechanisms in the United States (i.e., the Foreign
                             Bondholders Protective Council, which was created in 1934 and closed its doors in the 1980s) and the
                             United Kingdom (i.e., the Corporation of Foreign Bondholders, which was created in 1868).


                             Page 91                                  GAO/GGD/NSIAD-97-168 International Financial Crises
                                 Chapter 4
                                 Most Resolution Improvement Approaches
                                 Might Reduce U.S. Burden, but Many May
                                 Not Help Stem Contagion




                                 committee respond by saying that the existence of a mechanism to resolve
                                 sovereign debt arrears could eliminate some of the uncertainty that leads
                                 to contagion and damage to the financial system.

Communication and Burden         Proponents of a bondholder committee say that burden sharing could be
Sharing Could Improve            fairer, depending on the extent to which different types of creditors are
                                 represented on the committee. Also, supporters say that burden could be
                                 more appropriately shifted from creditor country taxpayers to the
                                 creditors themselves. One opponent of the committees responded that the
                                 mechanism may have trouble overcoming the diversity of bondholders.
                                 For example, such a mechanism would likely not appeal to mutual fund
                                 managers who have a short-term perspective and who often prefer to sell
                                 bonds that are not performing as expected. A bondholder committee could
                                 improve coordination and communication between parties in a crisis
                                 because of the committee’s attempts to minimize uncertainty about the
                                 locus of authority in negotiations. In addition, administrative burdens
                                 could be minimized because such committees could be developed, based
                                 on previous experience with existing institutions, such as the London and
                                 Paris Clubs. According to critics, the committee would not have the power
                                 to induce policy adjustments in debtor countries that would make the
                                 country less vulnerable to a future financial crisis.

Establishing Bond Covenants      Another proposal incorporating the cramdown principle suggested that
That Specify How                 specific covenants be included in sovereign bonds to facilitate potential
Debt-Servicing Problems Are to   future workout situations. The market could then lead the way to ensure
Be Resolved                      that creditors and debtors agree, before a bond is issued, on specific
                                 repayment conditions should a country be faced with a potential
                                 debt-servicing problem. The proposal suggests that specific covenants
                                 could address issues such as: how majority voting would take place to
                                 alter the terms and conditions of the debt contract (usually, unanimous
                                 consent of bondholders is required to change core bond covenants); how
                                 objections from creditors or debtors would be handled; and how payments
                                 should be shared among creditors.20 We were told that some Eurobonds
                                 governed by English law already have qualified, majority-voting clauses.
                                 The G-10 supported the idea of establishing bond covenants and reported
                                 that the private sector could take the lead in establishing such covenants
                                 with official sector support as appropriate.

Moral Hazard and Contagion       Proponents of establishing these bond covenants pointed to several
                                 advantages that they say the covenants would convey in resolving future

                                 20
                                   One report noted that to make such covenants palatable to lenders, dissenting creditors should have
                                 recourse to an arbitral tribunal. The proposal also noted that such clauses may be easily implemented
                                 because a form of bond covenants already exists.



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                                 Chapter 4
                                 Most Resolution Improvement Approaches
                                 Might Reduce U.S. Burden, but Many May
                                 Not Help Stem Contagion




                                 sovereign financial crises. They believe that such bond covenants could
                                 speed up the process of debt restructuring and could therefore limit the
                                 potential for contagion effects. Bond covenants could limit the ability of
                                 some creditors to stall or block the resolution process because they agree
                                 to abide by majority rule on possible repayment terms. However, bond
                                 covenants, unless they are activated extremely quickly, may be unable to
                                 stem the contagion effects of other emerging market countries. With
                                 regard to moral hazard, the G-10 reported that market participants believe
                                 that these covenants might increase moral hazard on the part of the
                                 borrower and consequently reduce the financial instrument’s
                                 attractiveness for the investor community. Other experts say that bond
                                 covenants would not create or enhance incentive for countries to default
                                 on their bonds since no country wants to risk the possibility of losing
                                 access to international capital markets.

Bond Covenants Could Improve     Bond covenants that specify debt-servicing problem or default workout
Burden Sharing, but Could Also   procedures to resolve potential liquidity crises may foster cooperation
Raise Costs for Sovereign        between creditors and debtors. In addition, bond covenants could provide
Borrowers                        for appropriate burden sharing between debtors and creditors because
                                 conditions could be agreed upon to ensure that creditors are treated and
                                 paid in a fair and equitable manner. Market participants who were critical
                                 of this proposal told us that bond covenants might raise the costs for
                                 sovereign borrowers because investors are likely to demand a higher
                                 premium as compensation for the inclusion of covenants in bond
                                 contracts. Some said that, if this happened, debtor countries might resist
                                 including these covenants in their bonds. Moreover, the G-10 reported that
                                 market participants believed that such covenants could reduce the
                                 attractiveness of emerging market bonds, which are usually viewed as
                                 simple securities that are easily transferable, unencumbered, and easily
                                 sold at any time the investor chooses. In addition, these bond covenants
                                 could pose unique administrative challenges because market participants
                                 believe it might be difficult to agree on the terms and conditions to be
                                 included in such covenants. For instance, market participants reported
                                 that they would be unlikely to agree to conditions that allow
                                 nonunanimous decisions by bondholders to change the schedule of debt
                                 payments. They also rejected that idea of majority voting clauses because
                                 they are viewed as infringements on creditor rights.




                                 Page 93                          GAO/GGD/NSIAD-97-168 International Financial Crises
Appendix I

Our Conceptual Framework for Analyzing
Initiatives and Proposals to Resolve
Sovereign Financial Crises
              We developed a 10-point conceptual framework to guide us in identifying
              the advantages and disadvantages of initiatives and proposals to resolve
              future sovereign financial crises. As part of our analysis of the initiatives
              and proposals, we sought to determine whether and how each could

              (1)limit contagion and systemic risk to the international financial system,
              including responding to a crisis with sufficient speed and quantity of
              resources;

              (2) affect moral hazard;

              (3) induce appropriate country economic and financial policies;

              (4) address the cost-effectiveness associated with development and
              implementation;

              (5) share burdens between parties in a sovereign financial crisis;

              (6) facilitate coordination and communication between parties in a crisis;

              (7) be flexible enough to deal with various types of financial crises;

              (8) apply principles consistently to countries in similar financial distress;

              (9) address the legal requirements needed for development and
              implementation; and

              (10)apportion the administrative burden of development and
              implementation.

              In developing the framework, we drew insight from the following:
              interviews with public and private sector officials, the list of desirable
              features that resolution strategies should have as developed by a G-10
              Working Party, and our past work.1 We then informally circulated a draft
              of our framework to obtain comments from officials representing our
              congressional requester; Treasury, the Federal Reserve; private capital
              market participants (commercial banks, investment banks, and mutual
              fund managers); academia; and one private research organization. Almost
              all of the officials generally agreed with the elements of the framework.
              However, in a few instances, some officials made suggestions to clarify
              some points within individual elements. Where appropriate, we

              1
               Farm Bill Export Options (GAO/GGD-96-39R, Dec. 15, 1995).



              Page 94                                GAO/GGD/NSIAD-97-168 International Financial Crises
Appendix I
Our Conceptual Framework for Analyzing
Initiatives and Proposals to Resolve
Sovereign Financial Crises




incorporated these comments to finalize the conceptual framework that
we used in our analysis.

As agreed with our congressional requester, we used our framework to
identify advantages and disadvantages of initiatives and proposals to
resolve future financial crises as they related to the U.S. government; U.S.
private sector creditors; and, to the extent possible, debtor countries. We
assessed information obtained from published reports and studies and
from interviews with U.S. and international public and private sector
officials.

In our analysis, we highlighted the framework elements that were most
important to the initiative or proposal being discussed, and we then
divided our analysis into two sections. First, we assessed the trade-offs
between two issues that were relevant to almost all of the initiatives and
proposals: (1) the impact on contagion to other countries and systemic
risk and (2) the impact on moral hazard. Second, we evaluated the other
criteria as relevant to each initiative and proposal. For example, one
initiative involved doubling GAB, which are lines of credit that G-10
countries maintain through IMF, to $47.6 billion.2 Our discussion of this
initiative’s advantages and disadvantages to the United States focused on
the three most salient framework elements: how the initiative responded
to contagion effects, how the initiative addressed moral hazard, and how
the initiative could spread the burdens for resolving crises. In this case,
our analysis of GAB did not focus on, to name two, the administrative or
legal requirements elements because neither were major issues or major
obstacles to implementation of this initiative.

We did not use the framework to endorse any particular initiative or
proposal. Furthermore, the relative importance of each element in our
framework is a matter of perspective.




2
 See chapter 4 for more information on this initiative and our analysis.



Page 95                                   GAO/GGD/NSIAD-97-168 International Financial Crises
Appendix II

IMF’s Special Data Dissemination Standard




              Page 96     GAO/GGD/NSIAD-97-168 International Financial Crises
Appendix II
IMF’s Special Data Dissemination Standard




Source: IMF.




Page 97                            GAO/GGD/NSIAD-97-168 International Financial Crises
Appendix III

Comments From the Department of the
Treasury




               Page 98   GAO/GGD/NSIAD-97-168 International Financial Crises
Appendix IV

Comments From the Board of Governors of
the Federal Reserve System




              Page 99    GAO/GGD/NSIAD-97-168 International Financial Crises
Appendix V

Major Contributors to This Report


                        Susan S. Westin, Assistant Director
General Government      Patrick S. Dynes, Senior Evaluator
Division, Washington,   Becky K. Kennedy, Senior Evaluator
D.C.                    Desiree W. Whipple, Communications Analyst

                        David T. Genser, Evaluator-in-Charge
National Security and   Thomas Melito, Senior Economist
International Affairs
Division, Washington,
D.C.
                        Paul G. Thompson, Senior Attorney
Office of the General
Counsel, Washington,
D.C.




(233492)                Page 100                     GAO/GGD/NSIAD-97-168 International Financial Crises
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