India's National Magazine
From the publishers of THE HINDU
Vol. 15 :: No. 26 :: Dec. 19, 1998 - Jan. 01, 1999
COLUMN
Washington divergence
A new World Bank report that questions the way the International Monetary Fund has sought to deal with the current global economic crisis, accentuates the tussle between the Bretton Woods twins.
C.P. CHANDRASEKHAR
IN Washington, it is a year of show trials. At the national level, the Senate strives to keep alive a trial of the President, based on issues regarding which both Democrats and Republicans switch sides at random. At the international level, one of the two Bretton Woods institutions, which have hitherto served as joint instruments of the G-7's international economic diplomacy, has chosen to join a campaign aimed at exposing the intellectual and practical inadequacy of the other. Of late, the World Bank has been questioning the role the International Monetary Fund (IMF) has played in dealing with a global crisis, in ways that exceed what the decorum of the dominant permits. The most comprehensive, even if undeclared, reflection of this tussle between the Bretton Woods twins, is the Bank's recent publication on Global Economic Prospects and the Developing Countries (or GEP for short in what follows).
The international economic crisis still manages to carry an East Asian prefix through verbal links such as contagion and fallout. GEP begins with a rather candid assessment of the global economic situation that has come to prevail since the East Asian crisis broke out with the devaluation of the Thai baht in July 1997. Global output growth is expected to halve, nearly, from 3.2 per cent in 1997 (3 per cent during 1990-97) to 1.8 per cent this year, and, even in an optimistic scenario, is expected to improve only marginally to 1.9 per cent in 1999. In particular, developing country growth is expected to fall sharply from 4.8 per cent in 1997 to 2 per cent in 1998, with 36 out of the hundred developing countries recording a drop in per capita income this year.
The problem, the World Bank admits, is deeper. To start with, the contraction in East Asia triggered by a financial crisis has proved to be more severe and protracted than expected in mainstream forecasts. In addition, it has been exacerbated by the conventional policy responses that have been imposed by the IMF in return for unprecedentedly large rescue packages.
Secondly, the tendency to shift between euphoria and panic in an imperfect international capital market has quickly transmitted the crisis in one country or region to other areas of the global economy. As a result, the financial crisis has not been restricted to East Asia, but has spread to other areas which include not merely the emerging markets in Russia, Eastern Europe and Latin America, but also more developed markets with strong and ostensibly more transparent financial systems.
Thirdly, as the effects of the crisis in the emerging markets begin to tell on the growth of world trade, the contagion is not restricted to countries with weak financial systems, but spreads to the developed countries that are dependent on global markets for their growth.
Finally, the liquidity crunch generated by panic in the capital markets and the protectionist responses generated by the slowdown in world growth make the task of forging a global recovery all the more difficult.
In the view of the Bank, the real danger if such a recovery is not ensured is a backlash against the wave of liberalisation and economic reform that has been unleashed across the globe since the 1980s. The potential for all countries to gain from freer trade and from expanded flows of foreign direct investment remains as compelling and valid as ever and indeed continues to increase with advances in transport and communications technologies. Developing countries will continue, as in the early part of the 1990s, to see the payoffs of almost two decades of economic reform and structural adjustment. It is to ensure the realisation of those predicted payoffs that the Bank seeks to draw some lessons from recent experience, which diverge from those implicitly drawn by the IMF.
THE World Bank's analysis is based on the belief that financial liberalisation and the financial integration of developing countries with world markets has proceeded way beyond the extent warranted both by the circumstances in those countries and the inherent imperfections in capital markets. The circumstances involved are the inadequate development of institutions needed to supervise and regulate financial agents, and the large build-up in liquidity that resulted in a surge of investments in emerging markets in the wake of financial liberalisation.
The imperfections referred to are basically of four kinds. First, information problems in capital markets, especially during a period of a credit and investment boom, which tend to raise temporarily the value of borrowers' collateral and blur the weaknesses in their balance sheets. This encourages lenders to provide excess funds to vulnerable banks and non-bank financial institutions.
Second, the fact that macroeconomic policy responses to large capital flows into developing countries tend to raise domestic interest rates and increase the spread between interest rates in developing and developed country markets.
TSUGUFUMI MATSUMOTO / AP
World Bank
President James D. Wolfensohn.
Third, the tendency for financial agents in developing countries to opt for risky short-term borrowing and even more risky investments in areas such as stock and property markets in periods when liquidity is easy to come by. And fourth, the observed tendency for financial investors to display irrational exuberance during periods of prosperity and excessive pessimism and panic behaviour when economic conditions change in a few locations. This results in cycles characterised by a surge in investment followed by a collapse in liquidity because of retraction.
According to the Bank, this combination of circumstances and imperfections creates the systemic conditions for a crisis. A surge in international capital flows following financial liberalisation encourages corporations, banks and non-bank financial entities to borrow far more than warranted by their capital base and to opt for risky short-term borrowing when long-term funds prove difficult to access. These funds are invested in lucrative but speculative areas like the property market, which in turn spurs a boom that enhances the value of the credit-financed investments that can be used as collateral. The net result is that these institutions are extremely vulnerable because they are over-leveraged, because they have an unusually high share of short-term debt in their books, and because they are excessively exposed to risky investments.
If and when changed conditions in one or more locations trigger a collapse of investor confidence, the crisis tends to be far deeper than expected with unacceptable social consequences, far quicker to spread to new locations and impossible to deal with by means of conventional IMF-style adjustment packages. In fact, IMF-style policy responses, premised on the view that balance of payments crises stem from the profligacy of governments, only tend to aggravate the deflation resulting from the severe contraction in liquidity that the sudden retreat of international capital implies.
THIS analysis, which the Bank has arrived at with hindsight, amounts to going back on perspectives and platforms that it has shared with the IMF during the 1980s and early 1990s, when they together virtually engineered a wave of liberalisation of the real and financial sectors in developing countries. In fact, without naming the IMF, the Bank's GEP argues that given the large declines in private investment and consumption, the initial policy responses to the crisis turned out, contrary to design, to be contractionary and would have been strongly contractionary if fully implemented.
The Bank itself now argues for a new set of short- and medium-term policies to meet the challenges of the current global environment. To start with, retracting from conventional stabilisation arguments in situations of balance of payments crises, it argues that the primary role of fiscal and monetary policy now is to alleviate the collapse in aggregate demand, expand the social safety net, and recapitalise the financial system in a non-inflationary manner, for which it sees financial support from the international community as being vital. Secondly, it argues that financial sector liberalisation, which increases the possibility of crisis, should proceed cautiously and in step with arrangements to enforce tighter regulation and supervision. Thirdly, capital account liberalisation should also proceed slowly, given the large risks and high costs of financial failure. Finally, in its view, changes are needed in the architecture of the international financial system in view of the excessive volatility, strong contagion effects, and increased scope for moral hazard in international financial markets, though the GEP document does not clearly spell out what the new architecture would involve. However, coming from an agency which in more insidious ways than the more transparent operations of the IMF permit shaped the process of liberalisation in developing countries, these conclusions do indeed spell a sea-change.
WHILE the lack of orthodoxy and the new caution displayed by the Bank are obviously welcome, what is striking is the concerted effort to lay the blame purely on the financial sector and to separate consciously liberalisation of production, prices, trade and foreign direct investment rules from financial liberalisation. The thrust of the argument appears to be that goods market liberalisation and integration are fine, but financial liberalisation and integration are bad. There is enough evidence to show that goods market liberalisation can be sustained by itself only if it leads to sustained export growth as well. However, success of the miraculous kind on the export front that the East Asian countries witnessed is the basis of its own undoing because, by raising wage rates, by appreciating the value of currencies and, in some instances like Thailand, by creating infrastructural bottlenecks, they undermine export competitiveness and tend to slow growth. Was the decision of the most successful countries in East Asia to opt for financial liberalisation unrelated to the growing evidence that they were no more the focus of export-based growth in the region or the world? Can dependence on developed-country markets prevent developing countries from succumbing to the pressure from international finance and their backers in developed-country governments? Such unavoidable, but ignored, questions, do suggest that the partial, though new, agenda of the Bank has more behind it than a willingness to learn from experience.
What that motivation could be is unclear. Speculation on the matter in the international financial press revolves around the personality and intellectual predilection against free financial markets of Joseph Stiglitz, the Senior Vice-President and Chief Economist of the World Bank, who has obviously authored more than the Foreword to the GEP report. But why does President James D. Wolfensohn, who comes from the financial world, accept his recommendations? One reason could be that financial crises across the globe have not merely seen the IMF's role in the developing countries increase tremendously but also the diversion of a huge share of resources the international community is willing to commit into the packages being put together and supervised by it. This did mean a whittling down of the role of the World Bank.
An analysis that challenges the credibility of the IMF and its programme, which supports trade and foreign investment liberalisation while calling for caution on the financial front where the IMF has a greater role to play, and which argues for a greater emphasis on reflation, reconstruction and the creation of safety nets, to implement which the Bank is the appropriate agency, does serve as a useful platform for a greater role for the World Bank. The divergence in Washington might have something to do with a real debate over the Washington Consensus that has dominated development policy until now, but it may more seriously reflect also the scramble for funds at the top.
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