Proceedings of the Standing Senate Committee on
Foreign Affairs
Issue 15 - Evidence
OTTAWA, Wednesday, April 29, 1998
The Standing Senate Committee on Foreign Affairs met this day at 3:21 p.m. to examine and report on the growing importance of the Asia-Pacific region for Canada (the Asian Financial Crisis and the role of the IMF, International Monetary Fund).
Senator John B. Stewart (Chairman) in the Chair.
[English]
The Chairman: Honourable senators, we will resume our work on the importance of the Asia-Pacific region for Canada. We will deal with the topic of the Asian financial crisis, and the role of the International Monetary Fund.
What has been happening in Asian financial circles is of great interest and importance to Canadians for several reasons. We are interested in the purely financial consequences to Canadians of the financial turmoil in certain Asian countries. We are interested the implications to Canadian exports and imports. We are interested in the implications for the political situation and the socio-economic order in those countries. We are also interested in the implications that this turmoil may have for the governance of the global financial community.
This afternoon we are fortune to have two genuinely expert witnesses. Dr. Solomon was with the Federal Reserve Board for many years. He participated in many international monetary negotiations during the 1960s and the 1970s. While on leave, he was the senior staff economist at the Council of Economic Advisors. He has also served as a vice-chair of the deputies of the Committee on Reform of the International Monetary System. He is a published author, and he holds the Distinguished Flying Cross. He is an officer of the Legion of Honour, and a recipient of the Rockefeller Public Service Award, an award which is given to relatively few people.
Our second witness is Dr. Catherine Mann, Senior Fellow at the Institute for International Economics. From 1984 to 1997 she held several posts at the Federal Reserve Board of Governors. She was the senior economist for the President's Council of Economic Advisors, and was the principle staff member for the chief economist of the World Bank.
She is now adjunct professor at the Owens School of Management at Vanderbilt University, and also teaches in the International Executive MBA program at the University of Chicago. She, too, is an author.
Please proceed, Dr. Solomon.
Mr. Robert Solomon, Guest Scholar, Brookings Institution: I shall first address the question of the importance of the Asia-Pacific region to Canada, and then I will refer to the role of the International Monetary Fund in the Asian crisis.
In terms of the import and export of goods and services as a proportion of the gross domestic product, the Canadian economy is far more open than that of the United States. In Canada, the proportion is 40 per cent, compared with less than 12 per cent in the United States. It will not surprise members of this committee to hear that roughly 80 per cent of Canada's merchandise exports go to the U.S., and that two thirds of Canadian exports come from there. Between 1990 and 1996, more than 90 per cent of the growth of Canadian exports went to the United States.
Canada's exports to all of Asia, including Japan, amount to about 8 per cent of its total merchandise exports. In the United States, that figure is 30 per cent.
Places such as China, Hong Kong, India, and Pakistan have not yet been seriously affected by the Asian crisis. If we omit them from the equation, Canada's exports to the remaining Asian countries, including Japan, were only 2.5 per cent of its total exports in 1996. It follows, therefore, that, in Canada, the direct impact of the decline in imports by the Asian countries in crisis will be relatively small.
The same holds true for Canada's imports, only 12 per cent of which come from Asia. In the United States, 39 per cent of imports come from Asia. As a result of the depreciations in the exchange rates of the countries in crisis, those imports are likely to rise. Since the direct impact on Canada's imports and exports will be relatively small, the obvious conclusion is that the effect of the Asian crisis on Canada will mainly depend upon its effect on the United States.
The International Monetary Fund's projections of economic growth in 1998 show a larger slowdown for the United States. They IMF has reduced its projection for 1998 U.S. GDP growth from 3.8 per cent to 2.9 per cent. It has made a smaller reduction for Canada, however, moving from 3.8 per cent to 3.2 per cent. The have done the same thing to the 1999 projections.
I will now look at the Asian crisis, and the role of the IMF. The crisis in the Eastern Asian countries -- Thailand, Malaysia, Korea and Indonesia -- has a number of causes. Among these are the weakness of Japan's economy, and the large depreciation of the yen in 1995-1997. This led to the over-valuation of the Thailand bhat. The depreciation of that currency in July 1997 started the crisis, and was a proximate cause of it. There were also some fundamental weaknesses in Thailand, among them a large current account deficit, and heavy bank borrowing from abroad. The IMF warned Thailand officials about this several times in 1996 and 1997, but to no avail.
Once the bhat depreciated, a contagion effect spread to other countries. Their exchange rates and stock prices fell steeply. That China, Taiwan, and Hong Kong have been spared is partly explained by the fact that they have large reserves of foreign exchange, which is not true of the four countries in crisis.
Once the crisis began, it was aggravated by deeper weaknesses. The term "crony capitalism" is a shorthand way to characterize those weaknesses which involve various forms of corruption. Governments were too much involved in economic and financial processes. In Indonesia, family members of the president received undue privileges in their business activities. In Korea, government officials told the banks as which conglomerates -- chaebols -- to lend to, and the amounts to lend them. Elsewhere, banks loaned too heavily against overpriced real estate while borrowing in foreign currencies, mainly dollars and yen. The result was that the banks were burdened with non-performing loans to domestic borrowers and heavy debts to foreign creditors.
As the foreign exchange reserves of Thailand, Korea and Indonesia were drained away, they found it necessary to apply to the IMF, and to accept IMF adjustment programs.
In the United States, the IMF has been widely criticized, and this has been unwarranted and unfair. In spite of the widespread use of the term in the media, the borrowing countries are not being "bailed out". The governments of the borrowing countries must meet stringent, often painful, conditions. These conditions pertain to government policies, and are designed to bring about the reforms necessary to get the countries back on their feet economically and financially.
Moreover, the funds borrowed are not made available in one lump, but rather in installments. If the countries fail to implement the conditions, they are not permitted to draw the next installment. The IMF is not just a lending institution. In its dealings with countries in need of funds to finance economic and financial reform, it is a disciplinarian representing the rest of the world. To be effective, a disciplinarian needs to have leverage over those in need of discipline. In the case of the IMF, that leverage is financing. The IMF can exercise its discipline over countries only when they need to borrow from it.
Some critics of the IMF argue that the free market should be relied upon to deal with these problems. It is not at all clear how the free market would reform crony capitalism as it exists in Indonesia and Korea, nor how market mechanisms would separate the cozy relationships of Korean banks and conglomerates, nor how the free market would introduce more effective supervision and transparency into the banking systems of these countries.
A frequent criticism of IMF programs is that they create moral hazard. In other words, the known availability of IMF loans is said to encourage both government policy makers and investors to make reckless decisions in the knowledge that the IMF will "bail them out". As I said earlier, however, governments do not get a free ride; they must meet IMF conditions that they would prefer to avoid. Private investors are not shielded from losses just because the IMF steps in to lend to a country with an ailing balance of payments. Surely individual and institutional investors who purchased securities in east Asia are suffering severe losses these days. As the prices of these securities froze, their dollar value went down as well.
American and other foreign banks are being required to roll over the loans that they made to the Asian countries. It remains to be seen what further sacrifices they must make. In the debt crisis of the 1980s, the IMF required the banks to come up with additional loans to debtor countries as a condition for its own lending programs. The banks finally had to take losses under the Brady plan in the late 1980s, which more or less put an end to that decade's debt crisis. It seems clear to me that it is not the purpose of IMF credits to permit banks or any other lenders to avoid losses.
As the recent meeting of the Interim Committee in Washington made clear, the architecture of the international monetary system needs strengthening in this world of highly mobile capital. The banks in many countries need to be reformed so as to improve transparency, increase capital, and adopt appropriate accounting standards. The IMF has a vital role in this process.
The IMF was created at the end of World War II. It was created in order to prevent a repetition of what happened in the 1930s, when countries in balance of payments difficulty imposed trade restrictions, engaged in competitive devaluations, and took other measures harmful to their neighbours and trade partners. The IMF's relationship with member countries is similar to that of a medical doctor; it is called in only when the patient is sick, and its task is to cure the malady and prevent it from spreading to the rest of the family. Doctors are not always immediately successful in these efforts, but they help to prevent epidemics, and we are better off with them than we would be without them. The IMF deserves support, and it needs additional funds.
Ms Catherine Mann, Senior Fellow, Institute for International Economics: I would like to comment on a couple of things that Dr. Solomon has brought up in his remarks, the first being the extent to which the Asian situation is a consequence of crony capitalism.
Any terminology is a caricature of the real thing. The "Asian miracle" was just as much a caricature of the actual goings on as is the caricature of crony capitalism. Asia was not a miracle, and neither is it a hot bed of crony capitalism. It is a little bit unfair to use those terminologies.
Dr. Solomon made some points about the underlying relationships between banks, governments, and the labour force. This implies that the financial system in those countries is a silent partner to a development strategy, and therefore does not play an independent role, as it does in other countries.
Certainly there was directed lending, and certainly there was a protected banking system. We can call that crony capitalism, but it is a development system that was very successful until the countries matured to the point where they were participating in international financial markets, but without a domestic financial structure that was up to the task. Of course it was not up to the task of allocating credit -- it had never been asked to do that before, and the government and business did not want to do it.
We ought to think of crony capitalsim as being the flip side of the Asian miracle. We should focus on the incentives that were set up for the organization of finance. We should also consider the business and labour relationships that were part of a web that, while very effective for a period of time, could not bear the burden of participation in the external market.
In that regard, to what extent can we expect the free market to help reform the systems in some of the Asian countries? While each situation is unique, we can say that the reformation of the country's entire development strategy -- including the relationship between business, government, labour, and finance -- is one package. This is why many of the IMF programs have increasingly focused on the structural reforms. These structural reforms go well beyond simply reforming the financial system, because the complex relationships between business, government, and labour cannot be unlocked by an underdeveloped financial system. The IMF programs have a very broad agenda that a number of people have criticized, but this is because such a broad problem cannot be solved by a narrow agenda.
There is one way that these reforms could use the engine of the free market to proceed. Specifically, one way to improve the workings of a country's financial system is to promote international competition. There are many benefits to having international banks participate in a domestic financial system. In the case of these countries, where supervision and transparency are very serious problems, it would seem to make sense to allow the participation of supervisors from another country. For example, when Citibank opens a branch in Korea, they are being supervised by the Federal Reserve.
In addition, some of these countries are very small. Their banking systems are very vulnerable to volatility in foreign exchange, as well as to volatility in economic activity within a country. The benefits of diversification of the capital base, as well as diversification of the loan portfolio, are quite clear. That diversification can be extended across international borders to the benefit of both the bank and the recipient -- bank or financial intermediary -- as well as to the recipient of the financial services.
There is a role for the free market to play, but it cannot do it alone. There is a need for regulatory change within these countries, to allow the participation of a broader range of financial service providers. That is an aspect of the structural reform programs that has, perhaps, been under-emphasized, in part because we know that these are very sensitive political issues. Offering competition to domestic financial systems is a very sensitive political issue.
I would like to discuss the issue of the IMF as an international lender of last resort, as it has been called. We all understand how a national lender of last resort works. I would like to bring that into the international environment, in order to consider what the IMF brings to being an international lender of last resort, and what it perhaps does not have to be a full international lender of last resort.
On the one hand, the IMF is the only institution that can coordinate action when sovereign nations are involved. We are talking about fast moving, global, financial crises that demand large and immediate injections of credit. Since the foundation for global growth is increasingly in international financial intermediation, we cannot risk a collapse of the international financial system. There is a real role for the IMF.
The IMF does not have, and probably should not be given, however, the key supporting mechanisms that are present in the national environment to mitigate moral hazard. Specifically, the IMF does not have and probably cannot be given a constant supervisory presence, nor a fiscal redistributive authority, nor the ability to enforce changes in financial structures. Since it does not have these important supporting structures that help to mitigate moral hazard, I would argue that IMF intervention -- not only in Asia, but also in Mexico -- has tended to magnify moral hazard.
On the one hand, the IMF needs to exist. In fact, I will argue that it needs to be strengthened in order to ensure that it will have the necessary injections of credit in the case of a crisis, and that we must limit the number of occasions of using IMF extension of credit. If we need to strengthen it, we also need to use it less frequently. What will take up the slack? What will be in a position to reduce the number of occasions on which we must call on IMF intervention?
The communiqué of the G-7 finance ministers has suggested a number of ways to improve the international financial architecture, as a consequence mitigating moral hazard and reducing the number of occasions that we must call on IMF credit. Improving transparency and disclosure, strengthening national financial systems -- these are clearly necessary. I would argue that these measures are not enough, however.
At the G-7 finance minister's meeting, several nations, including Canada, suggested that there should be an international supervisor of the national supervisors. This is an interesting idea, although if it would go beyond the measures in BIS in a question. In any case, I would argue that, in order to be effective, the supervisors must be ever present, and they must have enforcement powers. In my view, these are powers that individual nations are not likely to give to supra-national authorities. The fact that the IMF is only called upon when a country is in crisis means that, even if it were given this role, it would not be effective. By the time a crisis occurs, the supervisors are out of the picture. They must be there beforehand.
As a consequence, we must focus much more on market-oriented solutions to the moral hazard problem. In the context of the national lender of last resort, there is increasing recognition that the approach of the BIS capital adequacy guidelines creates a hurdle. Once a country sees itself on the other side of the hurdle -- once its banking systems meet the regulatory guidelines -- the indications are that it is safe. As a consequence, differences in national economic environments are not adequately taken into account in the regulatory guidelines. We believe that there is a much greater need for a focus on risk management techniques.
International financial intermediation is a very complex operation. There are a number of financial institutions that are the biggest players in these capital flows, and we must increasingly focus on risk management techniques within these organizations. That is, they are a way to manage risk, not to reduce it.
In this regard, though, there are a number of financial instruments that were not available prior to the onset of the Asian crisis. If they had been present, there might have been a different outcome. The fleeing of capital from these countries was a reason for the contagion, and for the collapse.
I can describe two sorts of financial instruments that financial engineers have the ability to create; credit insurance options, and roll over insurance options. If these instruments had been available, there would have been less need for investors to rush for the exits at the same time, unloading, for example, Korean bonds, which dropped from triple A to double B minus in the space of 10 days. If they had purchased a credit insurance option in advance, they would not have had to join the crowd leaving those countries because of regulatory constraints on the type of instruments that they could hold.
Why do these insurance instruments not exist? Why has the private financial market not come up with these insurance mechanisms? In the past, the need for these insurance mechanisms, these insurance options, has not been particularly evident.
During a period of fixed exchange rates, nobody thought foreign exchange options, foreign exchange swap contracts, and foreign exchange insurance were particularly important for companies or investors to have in their portfolios. The period of 1985 to 1989 clearly demonstrated the value of having these kinds of hedging mechanisms in place so as to diversify risk from those who did not want to bear it, to those who did want to bear it, or who could bear it.
A similar situation has developed with respect to some of these other instruments. In Korea and Indonesia, we can compare two different strategies for resolving the Asian crisis. Many people would suggest that the Korean resolution of the immediate crisis is advantageous. Korea met with the main commercial banks in New York in January, and they all agreed on how they would roll over the debt. In many respects, that was a successful resolution of the crisis for Korea and for the banks. However, it sets up no incentive whatsoever for the private market to develop its own insurance mechanisms to prevent the herding behaviour that led to the capital outflows.
Many people are decrying Indonesia for having disregarded the IMF programs. One aspect of their response to the crisis has been to take a hands-off approach; all private borrowers must agree with their private creditors and resolve the situation one on one. That is extremely costly and extremely messy for the lenders. It is exactly the sort of situation that induces the lenders to look for options that will protect them from this situation next time.
The financial engineers in New York are considering how to price these types of instruments. Whether or not anyone will buy these instruments, and whether or not such instruments would prevent turmoil next time, must wait for the next financial disaster to occur.
Senator Carney: I will deal with Dr. Solomon's remarks. You indicated that the main effect on Canada through our trading relationship with the U.S., and the effect on that country. I wanted to challenge that assumption.
In making that assumption, have you looked at the nature of Canada/U.S. trade? It is highly concentrated in areas like the automotive industry which may, in fact, have very little to do with Asia. You said that the direct impact on Canada may be very small. At this point, we do not know that.
I recently toured the Port of Vancouver, which is in my former riding. In 20 or 30 years I have never seen it so empty. The lumber docks were empty, as were other docks. For foreign designated exports, this port is the largest on the West Coast, and, perhaps, in North America. Business fell 17 per cent in the month of February. The port is stuffed with empty containers because the Asians can export to us, but they do not have the purchasing power to buy from us. The effect has been quite immediate. Every bit of land has empty containers on it. It is rembarkable. The newspapers have started to pick up on the fact that hundreds of longshoremen are unemployed, that the impact on that sector has been quite devastating, and that there is no end in sight. We should track what is happening in the port, and also what is happening in Prince Rupert, our other major port to Asia.
Given the nature of our trade with Asia, I think that you will find that there may be a much greater impact on Canada than you are suggesting. The nature of our trade varies. In Ontario, 90 per cent of our exports go to the United States. In British Columbia, less than 50 per cent do. Our biggest market is Asia, and the impact of the crisis could be much larger than you are suggesting.
You suggested that the IMF needs support and additional funds. There is nothing in your presentation, or in the material that we have been given, to indicate any public support for that. No one can tell us why the IMF has been so ineffective in alerting or anticipating the Asian crisis. No one has explained why it is has been so impotent in enforcing those tough measures you are talking about. You have said that the receipt of IMF funds is not a bail out, and that there are tough measures and criteria. However, no one has told us what would happen if Indonesia were to say they it would not obey the IMF rules.
In the Asia crisis, we see nothing to suggest that the IMF has earned our support; its credibility is still very much in the court of public opinion. The fallout from this Asian crisis will be considerable, and the experts to whom we have spoken think that the worst is yet to come. Given that, how can you still be so supportive of this institution?
The evidence suggests that the IMF has not been effective, particularly since we do not know what will happen if Indonesia does not in adopt the structures. Owing to the moral hazard that you so aptly described, there is nothing to indicate that these countries will make the required fundamental changes. I would like a little more candour on this point.
Mr. Solomon: As to your first point: I gave a very macro-economic picture of Canada's export. I looked at Canada's overall statistics, and I did not break my analysis down by region. It is true that Canada's total exports to those Asian countries are rather small, but I would not try to disagree with you about the specific effects.
As to the IMF -- it did foresee the crisis in Korea and Thailand. Several visits were made to Bangkok by IMB officials to warn them that trouble was ahead, but they were rebuffed. The IMF cannot force a country to act.
Senator Carney: The IMF seemed incapable of enforcing the strict measures that are a condition of the bail out.
Mr. Solomon: The IMF can enforce them only when the country is in need of IMF financing. It only has potency when the country asks for financing.
Senator Carney: To date that has not been proven in the Asian experience.
Mr. Solomon: It is still early. I have the impression that conditions are beginning to come around in Korea and Thailand. Some progress is being made in those two countries.
Indonesia, however, is still a mess, governmentally and economically, and it has not come around. I do not know what will happen if Indonesia does not agree to meet the IMF conditions. Indonesia would be in very serious trouble, but nobody can force a government to take actions that it is not willing to take. The IMF can only use its financing to enforce the conditions. If Indonesia were to refuse to meet the conditions, the IMF financing would be cut off, and Indonesia would remain in difficulties.
Senator Carney: Is there a precedent -- has the IMF ever walked away from a country because it failed to meet the rigorous tests?
Mr. Solomon: I do not know.
Ms Mann: The IMF delayed the first disbursement of funds to Indonesia because it did not alter its support of the national car program, and it did not close a variety of banks.
Senator Carney: I am aware of that. Dr. Solomon has said that the effectiveness of the IMF lies is its ability to demand and enforce quite strict tests and criteria. I am suggesting, and he has agreed, that this has not been proved in Indonesia.
Has the IMF ever walked away from a country on the basis that it had not met the tests? I am aware that it delayed, but has it ever walked away? Has it ever had to prove that its measures worked?
Mr. Solomon: I do not know the history of every IMF financing, but it has certainly walked away from Russia at periods. It stopped financing Russia until the country took desirable measures.
The Chairman: In Washington on April 16, Mr. Martin spoke about the IMF. He said:
However, recent events in Asia suggest that more needs to be done. Notwithstanding, the efforts to broaden surveillance to include the financial sector, an inadequate focus on financial sector issues was a key factor that inhibited early detection of the Asian crisis.
In the same speech he also said:
It is also important that the IMF enhance the transparency of its own operations and communicate its advice to its members and to the public clearly and with more candour.
The implication is that not enough attention was paid to the financial sector issues, and that there was -- and is -- a need to enhance the transparency of the IMF's own operations, and for the IMF to communicate with more candour. How valid are those implied criticisms?
Mr. Solomon: If the IMF had made its concerns about Thailand public in 1996, the crisis would have started in mid-1996 instead of in 1997. The IMF is not a whistle blower. It cannot make public the views that it is presenting to countries which it perceives to be in potential trouble. If it were to do so, there would be adverse market reactions.
Ms Mann: These issues came up after Mexico, as you recall. At the time, the IMF tried to enhance the transparency of the countries. That is, the transparency of the country's data, not necessarily transparency of the IMF's own assessment of the country. In terms of what is really necessary for a full understanding of how a country operates, that is a drop in the well.
When people ask for transparency of the IMF, they are asking the IMF to be a rating agency, which is not its role. We already have rating agencies. The IMF is not supposed to assess risks investments; that is the job of the private sectors and of the investors themselves. The IMF may well need to ensure that the private sector has all the information necessary to undertake its own assessments of risk, but that is something altogether different.
Senator Carney: You have put forward two interesting market based options; the credit insurance option, and the roll over insurance option. Some of the exporters who have appeared before us have told us that they require that. If they had some sort of export or credit insurance, it would help them to deal with countries whose financial institutions are not similar to ours.
Your solutions strike me as being helpful only on the exporter or investor side, however. Both roll over insurance and credit insurance would be helpful to the investor in a country, to the pension funds, or to the exporter to a country. It does not seem to demand any discipline on the domestic or importing side. Could you comment on that?
Ms Mann: In an equilibrium you must buy the option, and someone must sell it. The exporters will pay to have this insurance, and as a consequence, they will get a benefit, but the other side, the importers or the borrowers will have to pay for that too. Somebody must write the other side of the option.
This is most important, not as a discipline on the borrowing side, but as a way to prevent herding behaviour in a crisis. I see this as a way of diversifying risk away from a certain group of lenders to a more diversified set of lenders, thus altering the herding behaviour.
Senator Carney: It is an additional cost, so it would have to be universal, would it not?
Ms Mann: Not everyone will be so risk adverse as to buy such insurance.
Senator Stollery: When I think of the IMF, I must remind myself of that famous observation that "the fund is a bank and the bank is a fund." The IMF is actually the bank. A person would have to be mad to think that we should not have an international financial institution like the IMF.
I understand that IMF officials went to Thailand a few years ago. Perhaps it is better to provoke the crisis early on, as opposed to waiting. It might cost more to wait.
Last June the IMF put out a report on globalization. It listed South Korea, Taiwan, and Hong Kong, amongst others, as having arrived as industrialized nations, saying that they now had the financial institutions required to be part of the G-7/G-8.
What were they thinking when the issued that very important report? A few months ago they had to do a mea culpa for their own report. This causes me to question their competence. In that report, they listed the countries that are now accepted as First World industrialized countries. Within six months, one of them had a financial collapse. What about that?
Ms Mann: You must keep in mind that the IMF is only partly a research institution. It is basically a political body, and everything that is published from the IMF is sanitized to an extent that would probably surprise even politicians
The membership and the executive directors of the IMF will not allow anything to be prematurely published which makes them look bad. That is why none of the Article IV's get published except in sanitized form. The executive directors do not want them to be published; they do not want to publish a research institution's view of their country.
You are asking the IMF to do something that, because of its structure, it cannot do.
Mr. Solomon: I want to respond to the point about the promotion of these four countries to the status of advanced countries. Based primarily on the income levels that had been attained by the four Asian countries, they were added to list of industrial countries. This addition was not based on the nature of their financial systems or of their governmental systems, but on these real income levels.
It is conceivable that a country which has long been classified as an industrial country might, at some point, also have a financial crisis. It is not beyond belief.
Senator Stollery: No one asked the IMF to be a research institution, but they did publish a 160 page report. It was not just a pamphlet. It did not refer to them just as advanced countries. It specifically mentioned their advanced financial institutions, especially in the case of South Korea.
I just returned from three weeks in Japan. I read a very interesting article in the Japan Times, which I will be sending to members of the committee. The author of the article makes a very good point, in that, although we talk about free markets, free banking, et cetera, the only country that has not had a crisis is China, which has a controlled economy.
Japan represents 17 per cent of the world's economy, and it has a great impact on the countries in the Far East. People seriously talk about the fact that Japan will devalue the yen, and that this crisis is nowhere near over. While I was in Japan I noticed that, if you try to use the financial institutions outside of the major centres, there is a problem. The agricultural policy is also a big problem.
We have only seen the beginning of this problem. Everyone seems to think that the Chinese will devalue their currency by at least 30 per cent. The trick will be to conduct the devaluation and sack the 20 or 30 million people who are working for state enterprises that soak up money.
Do you think that there will be a devaluation in China? If so, do you think that the devaluation will be managed over two or three years, so as to sack those people and cause a minimum of social discontent and dislocation?
Mr. Solomon: The Chinese authorities have said that they will not devalue the currency. As it happens, I have recently examined the Chinese economy rather closely, and there is not much basis for a devaluation. My best guess is that they will not devalue. That said, they do have problems, and they will sack civil servants, as you suggested. They will do much more than that.
This new prime minister is a very interesting man. He has been a reformer for many years, and he will try to deal with the fact that China has many state-owned enterprises that are reporting losses, that have excess employees, and that carry on the system by which corporations provide medical care, education and housing to their employees. These enterprises which have financed themselves by borrowing from the banks, which now have a lot of non-performing loans. The banks are in trouble, as are many of the state enterprises. That all needs reform.
None of those problems will be solved by devaluing the currency and trying to increase exports. They are basic domestic problems, and they must be dealt with. The new prime minister will do his best to deal with them. I doubt very much that he will try to deal with them by devaluing the Ren Min Bi.
Ms Mann: I agree with Dr. Solomon completely on his assessment of the Chinese situation.
I have heard a number of percentages for devaluation thrown out, but I have never heard of 30 per cent as a target. Let us consider what a devaluation in China would do, and why it is that they do not need to take that step.
We know that a devaluation improves the relative price of exports, and therefore enhances the competitiveness of exports and overseas markets. We also know that a devaluation increases the costs of imports, and that has inflationary consequences for most economies.
On the export side, there is no need for a devaluation in China because the export industries are already highly competitive. China has the most modern factories, and the most highly educated labour. The country has a lot of tax advantages, so, in comparing China with other countries which have devalued, the productivity gains in the export industries outweigh any type of loss in competitiveness.
On the other hand, through imported energy and foods, the potential inflationary consequences of a devaluation will be much more widespread throughout the economy. In consideration of the tensions between the external sector and the domestic one, and of what must occur with a restructuring of the labour force and of industry, the last thing that China wants is to be faced with an inflationary environment where they must use monetary policy to constrain domestic demand or inflation. They are gaining politically by not devaluing, and there is no reason for them to devalue. They are getting tremendous political benefits, and they are managing their economic and political situation in regard to the exchange rate well. They need to do more work on domestic economy.
Senator Stollery: We talk about the open market and the free market, but the only country that seems to pass the financial tests is a one party state with a totally controlled economy.
Ms Mann: That is not exactly what I said. What I said was that they had significant difficulties with their financial market, but that they had effectively managed their foreign direct investment strategy.
Senator Grafstein: I have always been a modest, if not enthusiastic, supporter of the IMF. In the last year, however, there has been a diminution of support for, or fiduciary trust in, the IMF for a number of reasons. I have heard that the IMF triggered a bank run in Korea or Indonesia -- I do not remember which -- because it did not understand that there was a regulated infrastructure below the banks. In the short term, as The Wall Street Journal commented, it made the situation worse.
There is a general lack of enthusiastic support for the IMF. Canada has been very supportive of multilateral structures, and very supportive of the IMF. We gave funds to Mexico before the Americans did. We have been in the forefront of paying our fair share. There is a serious question that reaches deeper into our financial structures, however.
We must consider how the IMF applies, not to Europe or South America, but to Asia. We have been treating this situation as we would if it had occurred in Europe and the developed countries. We call Asia part of the international system. When you take a look at those countries, however, they do not have strong central banks. They do not have strong bank regulation, strong regulatory or rating systems, nor do they have private or public insurance. Why do we refer to the international system? A system means that structures are in place. It is not a system. It is a sieve.
Dr. Mann has suggested putting in insurance, and Dr. Solomon suggested increasing the funding for the IMF. At the end of the day, however, there is no structure in place to give us confidence that the financial instruments are in place in these countries. It is not crony capitalism, it is lack of regulation. Like it or not, there appears to be a more rigid, regulatory regime in place in China than in these other countries.
We have each spent time in China. There is a system of supervision or regulation. It is administered, it is not free market, and there are systems in place. We do not like them; they are rigid, costly, and ineffective. They are in place, however.
Having said that, is this not dissimilar from the situation that faced us immediately after the Second World War? Is it not time for very busy ministers of finance to really try to get a rerun, if you will, of Bretton Woods?
If these countries will be part of the global system through the WTO, it is time to take a fresh look at their banking and financial systems. Is it not important that we take a fresh hard, look, as opposed to an episodic look? Some ministers of finance come to meetings for just one day. They are so busy dealing with their own budgetary problems that they do not have time to focus on these issues.
It is time for a massive reformation that is based on the top regulators from the IMF, and from the other areas, sitting down together until they can come up with an accountable and acceptable plan.
We have accountable government here. Dr. Solomon has suggested that we should pay more money into the IMF. At this time, we would do so very reluctantly. We must account for the money that we spend, and I am not sure that we have the fiduciary trust in the IMF that we once did.
Mr. Solomon: It seems to me that you want the ministers of finance to get together and accomplish what the IMF is trying to accomplish in those countries in Asia that are in trouble now, to introduce better financial systems. The IMF programs are aimed at precisely that. I am not sure you need the ministers of finance to get together.
Senator Grafstein: The difference between the two is IMF has indirect or tertiary accountability. Ministers of finance have political accountability. There is a difference between ministers of finance who would be responsible for the money they collect and give to the IMF, and the IMF having this tertiary or less direct accountability.
Mr. Solomon: You want reform in Korea, Indonesia and Thailand. All I am saying to you, with all respect, is that the ministers of finance could sit down and talk to each other for days on end, but they do not have the same clout that the IMF does when Korea and Indonesia need financing which the IMF provides.
Ms Mann: You are making two points, and it is important to separate the them. One is how to improve the functioning of the financial systems in countries that have partially entered the international financial arena. When I say, "partially", I know that they are full participants in the trade side of the international financial system and, of course, we know that a lot of money goes along with trade, and in fact a lot more money goes around than is associated with trade. Those countries began participating in the international financial system without having the requisite financial structures.
It is important thing to note that the partial dismantling of the rigid regulatory environments in Korea was one reason they ended up in the situation that they are in now. If they had been able to, overnight, transform their domestic financial systems into strong, robust financial systems, then we would have had a different scenario.
However, if they had retained all of the rigidities inherent in the Chinese system, our discussion today would be to note the tremendous amount of inefficiencies that are associated with the rigidities of those systems. It is the partial adjustment that is the subject of our discussion today.
The G-7 finance ministers have said that the strengthening of national financial systems, this is a good thing, and we all agree on that.
Your second point, though, is the suggestion that it is time for a new Bretton Woods Agreement. That is a much bigger undertaking. The Institute for International Economics held a board meeting last Friday at which one of our board members, Paul Volcker made the comment that this was what the finance ministers of the G-7 countries are, in fact, doing. They may call it new international architecture for the financial system, but in his view, it is "interior decorating." Mr. Voker agrees with you. It is obviously not an easy task. Perhaps we could at least agree that we need more here than just new "draperies", but I am not sure that we have reached the point where people agree that we need more than new draperies, but I think that is because the crisis is still in another part of the world, not ours.
People do not talk about the collapse of the EMS, which is very similar to what happened in Asia. There were different ramifications because the internal systems of those EMS countries were much more robust. There are similarities that many people are choosing not to emphasize in part because, perhaps, doing so would take them down the path that they do not want to go on.
Senator Andreychuk: Everyone seems to think the IMF is more than what it is. As I understand it, the IMF does not initiate programs, but we seem to think that it is a guarantor of a country's performance. The IMF comes in when a country asks. At that point you have clout because you can impose conditions for assistance. The function of the IMF is not to call an alert when there is sign of trouble. Should that be its function, or should we look to other institutions to establish an alert system?
For example, if the WTO builds in more information sharing and transparency, perhaps that risk assessment can be done by private investors. Is it time to create a new institution?If so, once it is established, we will sacrifice some of our sovereignty for the sake of transparency. Would it be unfair to ask the IMF to take on some of these responsibilities?
Mr. Solomon: You have described the point very well, but there add one aspect. The IMF comes in when it is asked, but it examines all its members regularly. It was on the basis of that surveillance that it warned Thailand long before Thailand approached the IMF for help. The IMF does carry on at least part of the function you have in mind.
The problem is that the IMF cannot force a country to correct itself when it is headed for trouble unless the government of that country is willing to do so.
Senator Bolduc: Is the reform of the financial system in Japan is slow because they do not need money from anybody else?
Mr. Solomon: That is true.
Senator Andreychuk: I understand that, when the IMF moves in, on the one hand, it respects the sovereignty of the particular country but, on the other, it starts to do a lot more than the crisis demands of it. For example, if it is a short-term liquidity issue, they move in and start giving advice on all kinds of reforms that go beyond the liquidity crisis. In fact, the IMF starts asking countries in difficulties to do things that they would not ask of the countries that finance the IMF, and that is seen by some to be inappropriate.
Ms Mann: Does the IMF overstep its role? Once a country asks for a balance of payment support, then the IMF comes in with an entire list reforms. That has been a criticism of the IMF in the Asian situation in particular.
It is fair to say, there is no such thing as a simple liquidity problem. That is only the manifestation of a usually deeper structural problem, and these deeper structural problems are much more apparent in Asia than they were, for example, in Latin America where it was easier to point to macro-policies as being the source of the imbalances leading to the need for liquidity.
The situation in Asia did not involve standard sorts of macro-economic policy mismanagement. It was much more the development, over a long period of time, of the inefficiencies associated with a particular structural situation. Why the collapse was triggered the day it did happen, that is still a mystery.
I would argue that it is very rare that the IMF can only go in there with, "Well, I will give you a hundred dollars and then I will go away." It is more, "Well, I will give you a hundred dollars and you have to cut up your credit card and you have to reform your use of the telephone." That is something that you would do with a college student or whatever.
You also ask whether the IMF should be suggesting the same types of reforms to countries that are not recipients of IMF funds as they demand of the countries that are recipients of funds. Going back to the surveillance that Dr. Solomon mentioned, the so-called "Article IV" meetings, these are the occasions when these types of structural reforms are discussed and when the IMF does take to task various labour market issues, capital market issues or agricultural market issues with countries. However, since the IMF is not lending to those countries, it has no clout. We all know that we pay more attention to somebody who has money behind their words than someone who has only words.
The problem is not that the IMF is not talking to other countries about their internal workings, it is just that, in general, the European economies and the U.S. do not need the money, and so they do not listen very well.
Senator Andreychuk: Another criticism of the IMF is that it moves in too quickly to bail countries out, and that this is a disincentive to the banks and other lenders to solve their own problems.
Ms Mann: It is important to go back to the very early days of the crisis in the Asian countries. Do a careful assessment of what was actually happening in the first couple of weeks after the situation in Thailand became more apparent. The IMF was in there with a program worth $9 billion. They viewed that program as a relatively standard balance of payments support program. That was something the IMF had done before. That is what they viewed as being the necessary resources to solve the Thailand problem.
You recall that about the same time, there was the approach that the Asian Monetary Fund was an Asian problem -- the Asians will solve it in their own way. The $9 billion from the IMF turned into $17 billion. There was $5 billion or so from the Japanese. The result was that the IMF program was almost double what they had decided was necessary.
Whether or not that was the slippery slope that generated the reassessment of investors as to the status of their investments in other parts of Asia, we will never know. However, I question to what extent the IMF lost control of the situation as the Thailand situation was developing, in part because of geopolitical reasons. That is something which you cannot blame the IMF for, but it encouraged the type of situation where all the other Asian countries ended up with programs which put a very heavy demand on, not just IMF resources, but general world resources.
Senator Carney: You just described the slippery slope effects surrounding the Asian crisis. Is that, in your opinion, why the IMF appeared to be more effective in the Mexican crisis than in the Asian crisis? Clearly the IMF is deemed to have been more successful in Mexico than it was in Asia. Is it the slippery slope effect, or is it something else?
Ms Mann: This is very tough question.Any response would be conjecture. There is one fundamental issue to consider and then there is another issue that is more political. The fundamental issue is that, to a certain extent, the Mexican crisis was a crisis of macro-economic policy mismanagement. It had overlaid on that a financial system vulnerability and structural problems internal to the Mexican economy, but it was much more fundamentally a macro-mismanagement problem, over-valued exchange rate, large external deficit, excessive financial fiscal spending that nobody thought was there because it was being channelled through some off-budgetary items, but ex poste, it was more formulaic in terms of types of crises that we have observed in the past.
One can argue that the IMF's more familiar tools were more successful in the case of Mexico because the problem that those tools were designed to address could ameliorate those problems much more quickly.
In Asia, if you think of the problems as fundamentally not being macro-economic mismanagement but structural mismanagement, those problems build up overtime. They are hard to unwind. Consequently, injections of funds do not have the same kind of salutary effects as they do in the case of Mexico. It is much more difficult for IMF strategy -- regardless of how expansive the program might be -- to be effective when what you are dealing with is something that takes a very long time to change. You do not reform banking systems overnight. You do not reform business structures overnight. It is hard to be effective when you just give a big chunk of money. One of the reasons these things are tranched, is that it is an effort to keep the pressure on. That is the fundamental difference. I feel quite confident about that.
What is much more conjectural is the extent to which the Asian countries tried hard enough to solve their problems internally, specifically through interest-rate management to stave off the exchange-rate collapse. One way to prevent an exchange-rate collapse is to raise interest rates very high. Hong Kong did this to preserve the peg. In earlier crises in Sweden and Finland, they raised their interest rates by well over 100 per cent. France did the same thing in the EMS crisis.
If you look at the behaviour of interest rates of some of the countries in question in the Asian crises, it is open to question as to whether or not internal policy management tried hard enough, by using the interest-rate mechanism, to prevent a devaluation of their exchange rates. They would argue -- and I am sure others would as well -- that it did made no sense to use the interest-rate mechanism because there was such a change in confidence, such a panic on the part of investors, that no domestic interest rate would have prevented the exit of financial flows. Of course we will never know the answer to that.
I am more willing to accept that argument than to accept the argument that the domestic financial system could not bear a very high interest rate because most of the financial system was not really exposed to interest-rates mismatches to the same degree as they were exposed to foreign-exchange mismatches.
That is a much more conjectural way of thinking about the differences between the Asian and the Mexican crises, and why, perhaps, the IMF programs did not meet with equal degrees of success.
It is also very early in the case of Asia.
Senator Bolduc: The BIS recently initiated conferences on effective banking supervision to establish some rules. Should individual countries go through some accreditation process? Should they, say, have to comply with that set of rules as a precondition of joining the World Trade Organization or applying for help to the IMF?
Ms Mann: Yes. The core principles were developed partially in response to the transparency issue and the weakness of the financial systems that were in evidence in the case of Mexico. These are certainly minimum principles that would reduce the vulnerability of any financial system to the various sorts of shocks to which they must respond.
As to the accreditation idea, it may be a cart-before-the-horse problem. If adhering to the core principles is a precondition of IMF funding, what do you do when countries need financial assistance to get their financial systems up to snuff and to meet the core principles?
Senator Bolduc: I was also referring to the World Trade Organization. There would be a major incentive to obey the rules because, if they did not, they would be left outside of the system.
Ms Mann: The relationship between the WTO, especially the financial system agreements associated with the WTO, and those linkages to the core principles is an interesting issue.
Domestic financial systems can be importantly enhanced in their responsiveness to domestic borrowers as well in their robustness to respond to foreign shocks by the entry of foreign financial institutions. I would hesitate to make the core principles a precondition of WTO accession because I would like to see more countries in the WTO, especially from the financial services aspect of that, so that they would accept foreign financial institutions within their economy because I believe that enhances their ability to meet the core principles. However, there remains a cart-before-the-horse problem.
Senator Bolduc: Maybe you could build them into the MAI.
The Chairman: When Mr. Martin was in Washington at the IMF meeting, he said that the time has come to establish a new multilateral entity with a clear focus on the financial sector. He went on to talk about this.
Last Thursday, at a meeting of the Banking Committee of the Senate, I asked the Governor of the Bank of Canada about this proposal. His response was:
The point is that if these countries and institutions and these emerging markets wish to benefit from international capital flows, and from lending from industrial countries, there must be a standard of business behaviour that is seen by lenders as offering them a reasonable chance of getting their money back with interest.
The proposal made by the minister is for voluntary participation. It is a peer review process, where supervisors from industrial countries and emerging markets are part of a peer review that looks at the supervisory arrangements in individual countries. If a country wants to participate in that process, and if that peer review gives a reasonable mark, then it will be able to attract more capital.
I then asked him the following question:
Assuming that country X, a very important country, decides that it does not wish to participate, would it be proper, in your view, for Canada, in its position at the IMF or whatever the agency is called, to say, "In case there is financial difficulty in that country which affects investors from abroad, we will not support remedial intervention because of the moral-hazard factor"?
To which Mr. Thiessin replied:
That is a good question and it is difficult. If there were no circumstances that led your to take a more generous view, you might wish to vote that way, yes.
What do you think of that response?
Mr. Solomon: It was a tough question and I have sympathy for the governor.
The Chairman: Would you agree that we might wish to vote yes, unless of course there was some circumstance that might lead you to take a more generous view?
Ms Mann:We would vote "yes" to no intervention.
The Chairman: You are either in the game or you are out.
Ms Mann: There are a couple of issues here. One is free rider problems. Perhaps Canada, or whomever, might choose to not participate, but Canadian financial institutions might benefit from a decision by other governments to participate in intervention. That kind of burden-sharing can lead to political discussions.
The other point is that, by focusing on, for example, the core principles or this alternative strategy of requiring a standard of behaviour of voluntary participation in multilateral institution, supervisory institutions or peer review, we are only focusing on one side of the market, that is the emerging markets that are the recipients of the funds.
My suggestions on credit insurance options and roll over insurance options are in part to recognize that some of the difficulty that developed here was as a result of imprudent lending by international capital in the industrialized world. The response of the international financial community should be not only aimed at the borrowers to get their house in order, but also at the lenders to get their house in order as well. Both sides are in need of reform.
The Chairman: I know that one of the witnesses has a travel commitment, so if there are no more urgent questions, I would conclude the session at this point. Dr. Mann and Dr. Solomon, we are most grateful for your help. We have had a candid exchange. It has been highly beneficial to the committee, so thank you very much.
The committee adjourned.