26 SEPTEMBER 1998, Page 17


Deepak Lal doubts if the Prime Minister

is relying on the right body to beat global recession

THE RECENT debate between Peter Bauer and Cranley Onslow and Clare Short in these pages (Fifty years of fail- ure' and 'No, better than the previous 500', 5 September) is in a sense archaic. For its subject — development aid — is withering on the vine. It now comprises a diminishing fraction of the flows of for- eign capital to the Third and Second Worlds, and except for hopelessly man- aged economies — mainly in Africa — is dwarfed by private capital flows in the form of foreign direct investment, foreign bank loans and portfolio investments. All reasonably managed economies now seek and get these dep-oliticised flows in prefer- ence to the politicised aid flows — which come with all sorts of encumbrances. This decline in the demand for foreign aid is matched by a decline in its supply, as aid fatigue has overcome most of the donors. Instead of tilting at this windmill, Bauer and Onslow would have done better to target the International Monetary Fund (IMF) specifically, as its recent actions pose the most serious threat to the health of developing countries as well as to the emerging apolitical globalised private cap- ital market.

With the Asian financial crises seeming- ly spreading to Russia and now Brazil, there is a growing clamour, led by Mr Blair in his recent speech in New York, for a replenishment of the resources of the IMF `I'll be Bill Clinton, you be Kenneth Starr.' — supposedly at a low ebb — to prevent the world from sliding into a 1930s-style depression. But this supposed cure is likely to worsen the underlying disease, for the IMF, instead of being the solution, is increasingly the problem.

To understand this, it is useful to note that ever since its original justification as the overseer of the gold exchange standard created at Bretton Woods collapsed with President Nixon's closing of the 'gold win- dow', and the world moved to generalised floating rates — however dirty — the IMF has had no mandate. It has been like Pirandello's Six Characters in Search of an Author — in search of a play. It smartly stepped into the institutional opportunities offered by the 1980s debt crisis and the problems created by the post-1989 East European countries' move from the plan to the market. Whatever its achievements in these respects in the past — and they are debatable — the 1990s Mexican bail-out and the more recent Asian crisis show that its actions have exacerbated the problems of what economists call 'moral hazard' in emerging markets.

Moral hazard occurs in all existing bank- ing systems because national authorities implicitly or explicitly insure depositors against the bankruptcy of their banks. This allows the banks to overlend by making riskier loans in the knowledge that if these turn sour, their depositors will still be bailed out by the national authorities.

This moral hazard arising from deposit insurance was worsened by the distinguish- ing feature of the so-called Asian model of development. A central feature of this model — as seen most clearly in Korea but presaged by the development of Japan — is a close link between the domestic banking system, industrial enterprises (particularly the biggest) and the government. The fatal flaw in the Asian model — as shown by the recent travails of both Korea and Japan is that, by making the banking system the creature of the government's will, it accen- tuates the moral hazard that already exists because of deposit insurance. The banks have no incentive left to assess the credit- worthiness of their borrowers or the quality of the investments their loans are financ- ing, as they know — no matter how risky and overextended their lending — they will always be bailed out. This can lead to a mountain of bad paper and the de facto insolvency of a major part of the banking system — as has happened in both Korea and Japan — not to mention the corrup- • tion that is inevitably involved in this form of 'crony capitalism'.

These domestic problems of the Asian model were further aggravated by the actions of the IMF (beginning with the Mexican bail-out) and the entrance of for- eign banks as lenders in the newly liber- alised capital markets in the region. Of the three types of capital flows that can be dis- tinguished — foreign direct investment (FDI), portfolio investment and bank lending — the income and foreign curren- cy risks of the first two are shared by both the lender and the borrower, as the 'invest- ments' are denominated in domestic cur- rency. By contrast, foreign bank loans are usually denominated in dollars and the interest rate is linked to the London inter- bank offered rate (LIBOR). This means that, if faced by a shock which required a devaluation (in a floating rate regime), the domestic currency burden of the foreign bank debt rises pari passu with the chang- ing exchange rate. If this debt is incurred by the private sector, this rising short-term burden need pose no problem for the country, for, if the relevant foreign banks run, the borrowers can always default on their debt.

Now enter the IMF. The foreign banks faced by a default on their Third World debt have ever since the 1980s debt crisis argued that this poses a systemic risk to the world's financial system, and asked in effect for an international bail-out to pre- You shouldn't have asked for a large.' vent this catastrophe. Since then, and most clearly in the Mexican crisis in the early Nineties and the recent Asian crisis, the IMF has been more than willing to oblige. In its desperate search for a new role, it has become the international debt collec- tor for foreign money centre banks, as well as an important tool of American foreign policy.

The crisis in Indonesia provides the clearest example of this metamorphosis of the Fund. Before the Thai crisis hit the region, the Indonesian economy had been fairly well managed, despite the 'cronyism' of its capitalism. It had provided excep- tional growth rates, with a sensible deploy- ment of its oil revenues — unlike many other countries, e.g. Nigeria — which had made an impressive dent in its mass pover- ty. At the time of the Thai crisis, its eco- nomic fundamentals were sound: it did not have a massive trade or budget deficit, it had a flexible exchange rate, its debt bur- den was not onerous and its foreign bank debt was all private. When the contagion from Thailand spread, the foreign banks (mainly US and Japanese) which had made loans to the Indonesian private sec- tor ran, leading to a depreciation of the rupiah and a massive increase in the domestic currency costs of servicing this short-term debt. Many of the borrowers would then have defaulted, and that would have been that. Enter the IMF. Under pressure from the governments of the for- eign banks, it deemed that such private sector defaults would pose a risk to the world's financial system, and under the cover of the IMF programme the Indone- sian government was in effect forced to take on these private debts. The money from the IMF paid off the foreign lenders, and the general taxation of the Indonesian populace will have to repay the IMF. The Indonesian people have thus, through the aegis of the IMF, bailed out the foreign banks.

These actions of the IMF ever since the 1980s debt crisis have generated serious moral hazard in foreign bank lending. With the increasingly confident expecta- tion that they will be bailed out via the IMF no matter what the quality of their lending to Third World countries, foreign banks have no incentive to act prudently in their foreign lending. When this interna- tional moral hazard is coupled with the domestic moral hazard associated with the politicised domestic banking systems of the Asian model — as in Korea — there is double jeopardy. Foreign banks lending to domestic banks which know they will be bailed out will overlend, leading to ropy investments and an eventual debt crisis for the country.

With measures to remove the domestic moral hazard being widely adopted in the region, the international moral hazard inherent in the IMF's operations will still remain. What is to be done? The best solu- tion would be to shut down the IMF. Its original mandate ended with the Bretton Woods exchange rate system. Since then its continuance, though in the interests of its rent-seeking international bureaucrats, is no longer in the interests of the world economy.

It will be argued that the IMF is still needed as an international lender of last resort in a globalised economy. This is misconceived. There are two functions that a lender of last resort has to perform, as set out in Walter Bagehot's famous rules for the Bank of England. First, it should be able to create high-powered money (currency plus bank reserves) quickly to on-lend to solvent banks to pre- vent a liquidity crisis. Second, it must be able to distinguish between good and bad `paper' and thus judge the soundness of the banks to which it is extending liquidi- ty, the insolvent banks being liquidated. The IMF is incapable of doing either. It can lend only after lengthy negotiations with a country's government and with the approval of its board. Second, it has no way of sorting out the 'good' from 'bad' loans, for instance made by foreign banks to residents in the country, and to liqui- date the latter. The lender of last resort function for the money centre banks involved in foreign lending must there- fore continue to be provided by their par- ent central banks.

Nor is the argument that IMF condi- tional lending is required to induce recal- citrant foreign governments to liberalise their economies persuasive. The major cause of economic crises in most emerg- ing economies remains fiscal. As the con- tinuing crisis in Russia and the emerging one in Brazil demonstrate, there is little the IMF can do to instil fiscal rectitude unless domestic politics deems it to be desirable. As my study with H. Myint of the economic histories of 25 developing countries in the post-war period found (The Political Economy of Poverty, Equity and Growth, Oxford, 1996), liberalisation is undertaken only as a final desperate remedy once there seems no way left to close the fiscal gap. The reason is that the fiscal crisis is usually the result of the cre- ation of unviable, politically created enti- tlements to income for various domestic constituents. They will only be rescinded if the government has no way of financing them. By offering money on the promise of future rectitude, most of these govern- ments have just taken the money and run.

Apart from the bottomless pit that is Rus- sia, the example of President Moi's Kenya is salutary. He has sold the same adjust- ment programme to the IMF and the World Bank in exchange for their money thrice to date — with, of course, no com- pliance.

So, assuming realistically that the IMF will not be shut down, and that, with the recent fears raised about a global melt- down, its resources might even be replen- ished, what is to be done? I have a simple scheme which would mitigate the interna- tional moral hazard created by the IMF in countries where the foreign bank exposure cannot be suitably hedged; its extension to IMF lending might also provide its international bureaucrats with an incentive to be prudent in their policy lending. The scheme rests on the recognition that the main 'systemic' danger to emerging economies lies in foreign bank lenders not sharing in the foreign exchange risk associ- ated with these loans. A simple way of making them do so, and thus putting these loans on a par with foreign equity and FDI, would be to allow domestic residents to borrow only in local currency. Besides raising the costs of such borrowing implying an implicit tax — by imposing a capital loss on banks which run in a panic, leading to a depreciation of the currency, this enforced sharing of the foreign cur- rency risk should also give them pause. Extending the same policy to the IMF would mean that this 'bank's' short-term loans should also be denominated in local currency. As one major aim of Fund pro- grammes is to stabilise the currency, their success would now be judged by an honest balance-sheet item — the value of the payments it receives compared with the loans made in dollars. If its programme is successful, it should make a foreign cur- rency profit on its lending, if not, a loss. This would also mean that the benighted taxpayers of the borrowing countries would not have to bear a rising foreign currency denominated debt burden because of the past and continuing follies of their rulers.

The author is James S. Coleman Professor of International Development Studies, Uni- versity of California, Los Angeles.