Sachs: Stop preaching (fwd)

[Robert Weissman <rob@essential.org>]

                     Copyright 1998 The Financial Times Limited   
                             Financial Times (London) 

                  November 5, 1998, Thursday LONDON EDITION 1 

SECTION: COMMENT & ANALYSIS; Pg. 22 

HEADLINE: Stop preaching: 
PERSONAL VIEW JEFFREY SACHS: 
The G7 has stopped blaming the victims for the global financial 
crisis. Now it must give them a bigger say in reform: 

BODY: 
   When the global financial crisis broke out last year, the Group of Seven 
largest rich nations was quick
to seize on Asian misdeeds as the source of the crisis. This 
"blame-the-victim" approach was not only
erroneous but extremely harmful. The G7's rhetoric against "Asian crony 
capitalism", backed by the
International Monetary Fund's demands for abrupt bank closures, swingeing 
budget cuts, and
sky-high interest rates in the Asian countries, convinced the G7's own 
capitalists to cut and run, helping
to launch a worldwide panic. 

Last week, the G7 finance ministers adopted a far more constructive 
approach. True, the proposals
reflect many continuing flaws, especially a tendency to preach to developing 

countries. But if followed
up by real negotiations between creditor and debtor countries, the 
initiative will lay the groundwork for a
much improved international financial system. 

The declaration makes advances in four areas: 

* First, it calls for heightened supervision of creditor financial 
institutions, including investment banks,
hedge funds and offshore institutions. There is surely a serious problem 
here. The international banks
had lent just five Asian countries - Indonesia, South Korea, Malaysia, the 
Philippines, and Thailand - no
less than $ 175bn (#104bn) in short-term loans by mid-1997, perhaps twice 
the level of liquid foreign
exchange reserves in those countries. It was the flight of those loans, 
accelerated by the short positions
of hedge funds and investment banks, that brought down the Asian economies. 
At the same time, the
bail-out of Long-Term Capital Management, US hedge fund, exposed the G7's 
own variants of crony
capitalism, as well as serious gaps in financial market supervision in the 
advanced economies. Faulty
risk management practices in the international banks and weak banking 
supervision surely contributed
to the debacle. 

* Second, the G7 has come down firmly against the IMF tradition of secrecy. 
Recognising that it could
no longer preach transparency to debtor countries without exercising 
transparency itself, the G7 now
calls for a presumption "in favour of the release of information". Equally 
importantly, it calls for formal
mechanisms for external review of IMF operations. A good start would be for 
the IMF executive
board to hold open sessions to take testimony from outside experts. I am 
sure I would not be alone in
warning the executive board of the deep flaws inherent in any Brazil 
bail-out package in the context of
an overvalued currency and little large-scale private involvement. 

* Third, the G7 is more nuanced and realistic than previously about capital 
market liberalisation. Such
liberalisation, it acknowledges, "must be carried out in a careful and 
well-sequenced manner if countries
are to benefit from closer integration into the global economy". There is a 
lot of crucial detail left out of
the declaration. Will the G7 support, as it should, strong prudential limits 

on cross-border flows of
short-term loans? Will the Chilean approach of taxing short-term inflows win 

international approval for
the first time? 

* Fourth, the G7 recognises, albeit in muted terms, the failings of recent 
IMF bail-out loans, in which
private-sector creditors walked away with the IMF money, while debtor 
countries effectively
nationalised the private-sector debts. The early days of the Korean and 
Russian bail-outs were
particularly egregious. The IMF money went out to foreign creditors as fast 
as it arrived to the debtor
governments. The Korean debacle ended only when Korea ran out of IMF money, 
forcing the
inter-national bank creditors to agree to roll over the debts owed by Korean 

banks. (Scandalously, the
IMF stood by as the Korean government was cajoled into guaranteeing the 
repayment on the
rolled-over bank debts). 

In response to these abuses, the G7 declaration calls on the private sector 
to play a larger role in crisis
management and resolution, aiming at "orderly work-out arrangements" in 
which the private creditors,
rather than the official lenders, provide emergency financing. I have 
favoured this approach for years,
pointing out that US bankruptcy courts get working capital to municipalities 

and corporations in financial
distress not by the courts making loans themselves, but by courts approving 
standstills on repayments of
old debts and granting priority on new market borrowing by the bankrupt 
entity. The G7 has taken an
important step in this direction, though very gingerly, as the 
inter-national law in this area will have to be
built from scratch. 

On the down side, the G7 completely ducks some of the most important issues, 

especially international
policies on exchange rate regimes. A close reading of the emerging markets 
crises in recent years
leaves little doubt that pegged exchange rates have played a pivotal role in 

the onset of crisis. The logic
is roughly as follows. Countries undertaking macroeconomic stabilisation (as 

in Latin America) or
financial liberalisation (as in east Asia) pegged their exchange rates to 
the dollar as a
confidence-building measure. Initially, capital flowed in, tending to push 
up domestic prices in the midst
of an internal boom. As the boom peaked, the squeeze on exporters from the 
pegged rate became
clear. Investors therefore began to withdraw funds in anticipation of a 
devaluation. Eventually, the
central bank ran out of reserves in hapless defence of the exchange rate. 
The sudden market
recognition that reserves were depleted set the stage for a full-blooded 
financial panic. 

While the G7 makes important advances in financial market regulation, IMF 
openness, capital market
liberalisation, and orderly work-out arrangements, the headline grabber was 
the proposal for a new
contingency finance mechanism. This proposal can be either creative, or a 
further waste of time and
money. 

If such contingency financing comes in the context of flexible exchange 
rates, prudential limits on "hot
money" flows, and orderly work-out arrangements which put the onus of 
emergency financing on the
private sector, then the new facility can be a constructive part of the 
solution. If instead the IMF
continues to be the lender of first resort, aimlessly defending overvalued 
exchange rates while allowing
private creditors to make off with public funds, the new facility will add 
to global instability. Brazil will
be an early test of which of those visions applies. 

Let me make a categorical prediction. Until the poor are brought into the 
international financial system
with real power, the global economy cannot be stable for long. The G7 
countries, plus the rest of the
European Union represent a mere 14 per cent of the world's population. Yet 
these countries have 56
per cent of the votes in the IMF executive board. Even after a miserable 
year, the G7 declaration, for
all its advances, still reflects a haughty disregard for the rest of the 
world. There is no talk about
negotiation with the poorer countries, no talk about finding a fairer voice 
for those countries in the new
international system. The rest of the world is called on to support the G7 
declarations, not to meet for
joint problem-solving. 

It would be much better to build on tentative moves towards a true global 
dialogue such as the US's
initiative to set up the Group of 22 "systemically significant economies" 
and the UN secretary general's
call for the a United Nations role in global financial reform. The aim would 

be to ensure that a real
community of nations works to solve global problems. The G7 declaration 
looks forward to its next
summit in Cologne in 1999. For the good of the world, that summit should be 
a dialogue of rich and poor
together, not just a communion of the rich pretending to speak for the 
world. 

The author is the director of the Harvard Institute for International 
Development