G-24: The Developing Countries in the International Financial System 9781685854454

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G-24

G-24 The Developing Countries in the International Financial System edited by

Eduardo Mayobre Central Bank of Venezuela

b o u l d e r l o n d o n

Published in the United States of America in 1999 by Lynne Rienner Publishers, Inc. 1800 30th Street, Boulder, Colorado 80301 www.rienner.com

and in the United Kingdom by Lynne Rienner Publishers, Inc. Gray’s Inn House, 127 Clerkenwell Road, London EC1 5DB www.eurospanbookstore.com/rienner

© 1999 by Lynne Rienner Publishers, Inc. All rights reserved

Library of Congress Cataloging-in-Publication Data G-24 : the developing countries in the international financial system / edited by Eduardo Mayobre. Includes bibliographical references and index. ISBN 1-55587-846-6 (hc : alk. paper) 1. International finance. 2. Finance—Developing countries. 3. Group of Twenty-four. I. Mayobre, Eduardo, 1946– . HG3881.G128 1999 332'.042'091724—dc21 99-26297 CIP

British Cataloguing in Publication Data A Cataloguing in Publication record for this book is available from the British Library.

Printed and bound in the United States of America

∞

The paper used in this publication meets the requirements of the American National Standard for Permanence of Paper for Printed Library Materials Z39.48-1984. 5 4 3 2 1

Contents

Foreword, Antonio Casas-González Acknowledgments

1 2

3 4

5

6

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vii xi

Part 1 A Quarter-Century of Experience

The Developing Countries and the International Financial System: 25 Years of Hope, Frustration, and Some Modest Achievements Francisco Suárez Dávila The Future of the Group of 24 Aziz Ali Mohammed

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Part 2 Two Crucial Problems: Income from Oil Exports in the 1970s and the Asian Crisis in the 1990s

Oil Export Revenues and Their Circulation in the International Financial System Abdelkader Sid Ahmed

The Recycling of Petrodollars Francisco García Palacios

Lessons from the Recent Financial Crisis in Indonesia Anwar Nasution

The Financial Crisis in Korea: From Miracle to Meltdown? Yung Chul Park

The Impact of the Asian Crisis on Latin America Latin American Economic System v

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Contents

Part 3 Present and Future Challenges

The Process of Globalization Luis Enrique Berrizbeitia

Globalization and Development at the End of the 20th Century: Opportunities, Dilemmas, Tensions Andrés Solimano

10 New Capital Flows and Emerging Markets Ariel Buira

11 Dealing with the Volatility of Private Capital Flows Javier Guzmán Calafell

12 The Labor Challenges of Globalization and Economic Integration Victor E. Tokman 13 The Sustainability of Development Alfredo Eric Calcagno and Eric Calcagno

Appendix 1: First Meeting of Ministers, Caracas, Venezuela Appendix 2: Caracas Declaration II The Contributors Index About the Book

195 215 223 251

261 289

311 315 317 319 329

Foreword

The inaugural ministerial meeting of the Group of 24 (the G-24) was convened in Caracas in April 1972 at the invitation of the government of Venezuela. Twenty-five years later Venezuela again assumed the chairmanship of the group, and in February 1998 convened an extraordinary ministerial meeting. There had been many changes, often important, in the international financial scene during that quarter-century, both reflecting and affecting the political and economic evolution of the world. Developing countries and their role in the world economy also had changed, but the concentration of decisionmaking power in a number of developed countries and the need for concerted action among the former remained the same. In its first ministerial declaration, the G-24 “expressed its dissatisfaction that important decisions affecting the International Monetary System have been taken by a small number of developed countries to the exclusion and neglect of the interests of the rest of the international community, and that these decisions have adversely affected the economies of developing countries.” After the first 25 years, the Caracas Declaration II called for “the increased representation and participation of developing countries in the decision making organs of the international community to properly reflect developing countries’ growing influence in the world economy.” The limited role of developing countries in international financial forums does not mean that those countries are unaware that it is their own actions that are key to solving their problems. The Caracas Declaration II emphasizes that “the prime responsibility for development and poverty reduction in the developing world continues to rest with the peoples, institutions and governments of the developing countries themselves.” Nevertheless, part of that responsibility lies in ensuring that the needs and interests of those countries’ peoples are properly considered in the shaping of international affairs. This book is an account of the efforts made by developing countries in the field of international monetary issues, a reflection vii

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Foreword

on 25 years of hope, frustrations, and some modest achievements. It is also an examination of the present and future challenges of developing countries in a changing world. With the increasing globalization of the world economy some developing countries have become more active in international affairs, while others face the risk of marginalization. What remains unchanged is that poverty and insufficient means for development are concentrated in a part of the world where the majority of the population lives, while the means of production and the decisionmaking power are concentrated in but a few countries. This state of affairs is one of the reasons that developing countries feel the need for a coordinated approach to dealing with world politics, and the G-24 is one of the best examples of such coordination implemented in a sustained, serious, and technically sound way. The G-24 was constituted by the Group of 77, a forum of developing countries that coordinate their actions within the framework of the United Nations. The G-24’s membership, reflecting a wide geographical range, represents the totality of developing countries. Its creation was a reaction to the breakdown of the Bretton Woods monetary system in the early 1970s and the subsequent turmoil in international financial affairs. The establishment of the G-24 was meant to achieve a greater and more active participation in the reform of the international system, which at the time was still being shaped by only a few members of the international community. From the outset the G-24 recognized, as stated in its first ministerial declaration, “that the institution for decision making on international monetary matters should be the International Monetary Fund.” Also from the beginning, the hopes raised by the prospect of an internationally concerted action for promoting world development and reducing poverty and income disparities led the G-24 to deal with matters not strictly monetary. For example, there was the creation of the Development Committee (or Joint Committee of the International Monetary Fund and the World Bank for the Transfer of Real Resources to Developing Countries), which was a landmark in this regard, as was recognizing the importance of the sustainability of growth. This book reflects both the experiences of the developing countries with monetary matters and the ample agenda the countries face today. It reviews past actions and positions, but deals as well with issues of current interest and with matters that are seen as important for the future of international economic relations. Chapter 1 traces the relationship of the developing countries with the never completed reform of the international financial system and with the multilateral organizations. Chapter 2 considers the future of the G-24: What should be its role as a forum of developing countries? What are the more important issues that it should address?

Foreword

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Chapters 3 and 4 look back at the role of income from oil exports and its circulation in the international financial system, a major determinant in the evolution of monetary and economic issues in the 1970s and 1980s. Chapters 5, 6, and 7 explore the early stages of the current Asian crisis through the lens of the national experiences of Indonesia and Korea, as well as in terms of its impact on Latin America. Chapters 8 and 9 deal with the process of globalization as the general framework of international economic relationships. Chapter 10 then focuses on the new capital flows and emerging markets, and Chapter 11 discusses the volatility of private capital flows. Chapter 12 assesses the challenges faced by labor as a result of globalization and economic integration. In conclusion, Chapter 13 considers the sustainability of the development process. The authors, all distinguished scholars from developing countries, have had direct practical experience in international relations and policymaking. Their familiarity with the endeavors of developing countries, and in particular with the actions of the G-24, provides insight into the continuing efforts of those countries to express, coordinate, and advance their positions and interests. The Central Bank of Venezuela is very proud to have sponsored this volume, which it feels will contribute to a better understanding of the role of developing countries in international affairs. Special emphasis has been given to the means and possibilities for action and to the challenges and opportunities presented by the current international environment, particularly in relation to the international financial system. The occasion of the 25th anniversary of the creation of the G-24 provides an opportunity to present the points of view of developing countries on issues that are shaping our present and our future. Antonio Casas-González Chairman (1997–1998), Group of 24 President, Central Bank of Venezuela

Acknowledgments

William Larralde, chairman of the Deputies of the Group of 24, gave inspiration and guidance for the development of this book. G. K. Helleiner, professor of economics at the University of Toronto and head of the G-24 research program, gave invaluable advice. Aziz Ali Mohammed and Clara Pasquali, of the G-24 Liaison Office in Washington, D.C., and Alicia Garcia of the Central Bank of Venezuela provided technical and logistic support. I am deeply indebted to all of them. Eduardo Mayobre

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PART 1 A Quarter-Century of Experience

1 The Developing Countries and the International Financial System: 25 Years of Hope, Frustration, and Some Modest Achievements Francisco Suárez Dávila

In 1997, the intergovernmental Group of 24 (the G-24)* reached an institutional life of 25 years, having met first in April 1972 in Caracas. After a quarter-century, Venezuela again held the chairmanship. During this quarter-century, some of the most dramatic changes in history have occurred; but in some respects there have been no changes at all. In 1972 the developing countries played a very small role in international monetary affairs. Their share in world trade was around 25 percent; in international reserves, 22 percent; and in International Monetary Fund (IMF) reserve positions, 16 percent. They were represented by only nine out of twenty executive directors on the boards of the Bretton Woods institutions. The developing countries had for the most part fixed-exchange or multiplecurrency practices and exchange controls, and their levels of international debt were reasonable. The Bretton Woods system had been dealt a serious blow in 1971, with the suspension of dollar convertibility. In the succeeding years, the developing countries became key players in the energy crisis of 1973 and the debt crisis of 1982. Two new Bretton Woods institutional bodies were created: the Interim Committee and the Development Committee. Par values of currencies were replaced by widespread floating, but with a consolidating process leading toward the dawn of European monetary union. Some years later the Berlin Wall fell, and now even the former socialist economies are players in the system and have joined the IMF and the World Bank. There are now industrial, transitional, emergent, and developing countries. The international financial system has been affected by the “first crisis of globalisation into the 21st century”—the *The Group of 24 is made up of: Algeria, Argentina, Brazil, Colombia, Congo (formerly Zaire), Côte d’Ivoire, Egypt, Ethiopia, Gabon, Ghana, Guatemala, India, Iran, Lebanon, Mexico, Nigeria, Pakistan, Peru, Philippines, Sri Lanka, Syrian Arab Republic, Trinidad and Tobago, Venezuela, and Yugoslavia (currently inactive).

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Mexican events of 1994—and already another crisis has erupted, also related to massive capital outflows and affecting what had hitherto been considered the “wonder” side of the world economy, the Asian “tigers.” To top it all, the traditionally booming Japanese economy has been suffering from a period of stagnation. Even though the developing countries have grown in economic importance—and there is now recognition of a new group, the Group of 5 (China, Russia, Brazil, Indonesia, and India), with its increasing share of world trade and gross domestic product (GDP)—some of the old problems remain unchanged. There is the problem of balance, which is perhaps now related more to capital, the need for the transfer of real resources being more pressing due to the growing inequality between the industrial and more advanced developing countries. The debate continues about the IMF’s oversight and its lending conditions, as well as the role of the Bretton Woods institutions. The Group of 7 (G-7)* (and not even the G-10†) goes on making major system resolutions by itself. There is still the argument about lack of participation by LDCs (less developed countries) in the decisionmaking processes in regard to the main economic issues. There has been the shift from the Keynesian pensée unique toward “neoliberal” thinking and its prominence in Washington, D.C. (though there are now signs of some rethinking). Most recently, economic globalization, with its benefits and costs, the increasing concern about social cohesion, and the requirements of the environment and sustainable development are demanding close attention. Just these few issues illustrate the evolution of the world scene that occurred between the first and the 58th meetings of the G-24. With this background we will survey the group’s history. The Role of the Developing Countries in the Belle Époque of the International Financial System (1946–1970)

It is generally assumed that the developing countries did not play a role in the early stages of postwar international monetary cooperation. However, their participation at the Bretton Woods Conference was important. Fortyfour countries participated, including all the Latin American countries and India, Iraq, Iran, China, Egypt, Ethiopia, and the Philippines. All played a role in the conference committees. John Maynard Keynes chaired the one for the World Bank and Harry White the one for the IMF, but a third committee, dealing with other means of international financial cooperation, was chaired by Mexican Finance Minister Eduardo Suárez. Among other *G-7: United States, Great Britain, Germany, France, Italy, Japan, and Canada. †G-10: The G-7 plus Sweden, Belgium, and the Netherlands.

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5

topics, this committee had to deal with the problem of silver, of importance to developing countries like China and India. The major contribution was the Mexican proposal presented in the session of 12 July that the Bank for International Reconstruction, geared to European reconstruction, should also be used for development.1 In the consideranda for the proposal two important points were made:

1. “In the short term, possibly reconstruction will be more urgent for the world in general. But in the long run, before we are all dead [a reference to the Keynesian phrase], the concern for development will prevail.” 2. “We have supplies of gold and international reserves in unprecedented levels; we speak for the Latin American countries. We can devote these resouces to import capital goods for our development but we want our projects to be put on an equal footing with reconstruction.”

Hence, the World Bank became the International Bank for Reconstruction and Development (IBRD). Over the succeeding years, the developing countries benefited from the belle époque period of world growth of the 1950s and 1960s, pushed forward by Marshall Plan aid and European reconstruction, the Korean War and Asian reconstruction and development, the process of European integration, and resource transfers related to the Cold War competition and the initial period of dollar “glut.” The developing countries adapted their economies, with different institutional arrangements (e.g., central planning, mixed economies) and varying degrees of economic success, during what for many countries in Asia and Africa was the first “transition” from colonialism to independence (the second transition being from socialism to a market economy). The system started to show signs of strain in the late 1960s, with the dollar shortage and problems related to the insufficient stock of gold and the fiscal and external deficits of the United States aggravated by the war in Vietnam. Since the mid-1960s the G-10 deputies, under the leadership of Otmar Emminger and Rinaldo Ossola, had been working on the creation of international reserve assets to replace the dollar in the international reserves of major countries. The resulting idea was to create the special drawing right (SDR), but the initial proposal was to have a limited distribution, mainly to G-10 major industrial countries. The developing countries had been engaged in preparation for a special United Nations Conference on Trade and Development (UNCTAD I) to be held in Geneva in 1964. For this meeting, the Group of 77 (soon to be increased in number) was created as the forum to coordinate the positions of the group’s members. One of the first actions was to push for

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A Quarter-Century of Experience

creating an SDR that should have universal distribution and to discuss SDR rules within the IMF. The smaller European countries supported this view. The principle was finally agreed on, and joint meetings took place between the G-10 deputies and the Executive Board of the IMF. This led to another important mechanism to coordinate the views of the developing countries: the G-9, the group of executive directors representing developing countries on the board of the IMF and the World Bank. The Articles of Agreement were amended in July 1969, and the first distribution of SDRs to all the IMF members began in January 1970. Thus, the first stage of cooperation in international monetary affairs by LDCs—to prevent decisions affecting the entire system being made by only a few countries— had been achieved. It was the first important institutional result.2 The proposal also was made that there should be a link between the creation of SDRs to satisfy the liquidity needs of the system and the transfer of real resources to developing countries. The Creation of the G-24: How the LDCs Organized to Participate in the International Reform Process (1971–1972)

The unilateral decision by the United States government in August 1971 to officially suspend the convertibility of the dollar to gold gave a severe shock to the system, and essentially dealt a death blow to it as it had been functioning since Bretton Woods. In the Smithsonian Agreement achieved in Washington, D.C., by the G-10 ministers a new currency alignment was achieved between the falling U.S. dollar and the appreciating Japanese yen and European currencies. There were also two important decisions: (1) to initiate discussions about the reform of the international monetary system, and (2) to carry out reform with meetings between the G-10 and the Executive Board within the framework of the IMF. In September 1972 the IMF Executive Board presented a document setting out the issues for the reform of the system, and the Committee of 20 to negotiate that reform was created on 18 September 1972. After the Smithsonian “shock” the tempo of meetings and negotiations among developing countries also increased. The first step toward the creation of the G-24 was the second ministerial meeting of the G-77 held in Lima, in November 1971, where the decision was taken to create a special group to consider international monetary issues. That body approved the declaration and principles of the Action Program of Lima, which contained a statement on a theme that unfortunately would recur from time to time: “It is entirely unacceptable that vital decisions about the future of the international monetary system, which are the concern of the entire world

The Developing Countries and the International Financial System

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community, are sought to be taken by a limited group of countries outside the framework of the IMF.” Discussions then took place to establish the characteristics of the new negotiating group of developing countries. The preparatory meeting of deputies of the Intergovernmental Group of 77 on International Monetary Affairs took place in Geneva, chaired by the representative from Peru, and set out a tentative program and a working structure that had as basic elements the following: 1. There would be two levels of discussion: the deputies at technical level and the ministers to achieve political consideration. 2. Both levels would have a chairman and a deputy chairman. The ministers would have a second deputy chairman and the deputies a rapporteur. 3. Regional representation would be achieved by having eight members per region.

The first meeting of the G-24 was held in Caracas, at deputy level, 3–5 April, and at ministerial level, 5–8 April 1972. The ministerial meeting was chaired initially by the foreign minister of Peru, Guillermo Marco del Pont. After the election, Pedro Tinoco, minister of finance of Venezuela, became chairman; M. S. Mostefai, governor of the Central Bank of Algeria, and W. N. Perera, minister of finance of Sri Lanka, became vicechairmen. Carlos Rafael Silva of the Central Bank of Venezuela, who had been previously elected chairman of the deputies, acted as rapporteur. Lal Jayawardena, who in the future was to make frequent contributions to the intellectual work and the participation of the LDCs in the reform process, was elected vice-chairman of the deputies. M. Falegan of Nigeria acted as rapporteur. It was an important shift in the framework of the G-77 to have established a specialized body of finance and central bank officials to carry on the work related to international monetary affairs. Pierre-Paul Schweitzer, managing director of the IMF, and Manuel Perez Guerrero, the secretary general of UNCTAD, attended the meeting. The work of the G-24 would be supported in the future by the staffs of the two institutions. The group referred to several procedural and substantive aspects in its first communiqué: 1. The group considered that the most important task facing it at the moment was to provide for fundamental improvements in the decisionmaking process regarding international momentary issues. The group agreed that the institution for decisionmaking on international monetary matters “should be the International Monetary Fund” and unanimously favored the creation of a committee of a board of governors of the IMF (the Committee of 20)

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2. It supported the idea of a new activation of SDRs from 1 January 1973 determined by the liquidity needs of the world economy. 3. The group gave its fullest endorsement to the establishment of a link between SDRs and additional development finance. 4. It expressed its dissatisfaction with the present system of developing country IMF quotas.

At the UNCTAD III held in Santiago de Chile three weeks later, the communiqué was endorsed. The G-24 had its second meeting in Washington, D.C, preceding the first meeting of the Committee of 20 on the reform of the international monetary system, a feature that would become a modus operandi of the group. By the time of that meeting, reports had been prepared by the deputies, relating to the main points stated in the first communiqué: the objectives of the reform of the system, allocation of SDRs for a second basic period, net transfers of financial resources, and the quota structure of the IMF. A number of technical papers had been prepared by a very wellqualified group of experts that would continue to play a role in the future: Sidney Dell (UNCTAD), Carlos Massad (Chile), Ricardo Arriazu (Argentina), and Alfredo Phillips (Mexico). Professor Robert A. Mundell and E. M. Bernstein had papers commissioned by the Bank of Mexico; however, the topics at that early stage were still quite limited. From the “Unreformed” International Monetary System to Its Evolutionary Process (September 1972 to 1982)

After September 1972 there was a period of hope, when it was considered possible to construct the blueprint for a new international monetary system to replace Bretton Woods. Those hopes were shattered after the dramatic adjustments and the instability that followed the sharp increase in oil prices at the end of 1973. After January 1974, there was a search for an interim solution, which took basic shape in the Accord of Jamaica in January 1976. Afterwards immediate “reform” gave way to an evolutionary process for the system. If one compares the basic objectives for negotiation and the features that finally emerged in the system, one can appreciate how much the results deviated from the initial path and how far the vehicle of reform wandered from its destination: • For the “exchange rate” policy, there was an attempt to substitute the par value system for one of fixed but adjustable rates. This in turn gave way to a system of floating guidelines. The system

The Developing Countries and the International Financial System

• •

• • •

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became centered on three floating anchors—the U.S. dollar, the Japanese yen, and the German mark. After long discussions about the search for a symmetrical adjustment system, with objective indicators versus discretionality, the topic became largely irrelevant. The debate about international liquidity and the development of a new international reserve asset meant, in practice, a phenomenal growth of the reserve currencies of the three major players, and only three minimal and meaningless allocation periods of SDRs. The numéraire of the system continued to be the dollar. The question of the real transfer of resources became a huge recycling of petrodollars to developing and developed countries that eventually led to the debt crisis of 1982. Some important institutional changes occurred as the Interim Committee and the Development Committee were being created, as well as during the G-5 and the G-7 summits after Rambouillet, France, that also made the G-10 less relevant. Multilateral surveillance eventually gave way to debtor surveillance and credit conditionality from creditor countries via the international organizations.

There were three basic phases to the above process.

September 1972 to January 1974: The Period of Hope for a Reformed System

The first one was a very hopeful phase, after the first Committe of 20 meeting in September 1972, at which the deputies under the able chairmanship of Sir Jeremy Morse set out to prepare an outline of reform. In March 1973 there was already in place a “system” of globalized floating rates. By May there was an outline of reform that could not be agreed upon. In September the energy crisis began. By January 1974 it was clear that any hope of integral reform had to be abandoned.

January 1974 to January 1976: The Patching of the System

It became clear that there was a need to achieve a transitional monetary system—the so-called interim reform—and at the same time to take emergency policy measures to cope with the problems of the oil-importing countries, both developed and developing. Thus the Committe of 20 passed from the scene in October 1975. It was replaced by the Interim Committee (on monetary reform), which has

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become permanent, and the new Development Committee. There was a move toward increased quotas, the fifth general increase, enlarged access to fund resources, and increased borrowing by the IMF in which rich oil-exporting countries substituted for many oil-poor industrial countries. A number of new lending mechanisms were established, such as the oil facility, the extended fund facility, and the supplementary facility. The compensatory financing facility was made more flexible: this entailed expanding amounts of borrowing, extending drawing and repayment periods, and making some drawing mechanisms better suited to the prevailing world conditions. A part of IMF gold was sold to create a trust fund that could give subsidized support to the least developed, most seriously afflicted countries, and to revert gold to some countries’ “gold bugs.” At Rambouillet, in November 1975, the first G-7 summit was born and an agreement was reached by heads of state to set up a new way to regulate exchange rates. The way was paved for the Jamaica Agreement of January 1976 that set off the process toward the second amendment to the Articles of Agreement of the IMF (the first being that of the SDR). This second amendment established the SDR as the basic “formal” unit of the system and buried the gold exchange standard. Gold ceased to have an official price, floating was legalized, and the IMF was transformed into a formidable lending and borrowing institution. It set up machinery for international dialogue and consultation between finance ministers and central bankers representing the different economies. January 1976 to June 1982: The Beginning of the Evolutionary System

This set up the evolutionary phase of the monetary system through the period from January 1976 to June 1982. This was a highly unstable and difficult period. Important industrial countries, such as the United Kingdom and Italy, made massive use of IMF resources. The second oil crisis of 1979 triggered yet another oil price increase, this time to $18 a barrel. Inflation and deflation, coupled with stagnation, in industrial countries (stagflation) caused severe problems to the world economy. After 1980 most industrial countries took the decision to adjust their disequilibriums. This meant the reduction of inflation, a drastic increase in real interest rates, and the largest fall in world output since the Great Depression. Up to this time, developed and developing countries had simply been able to finance their deficits, considering that the problem was transitory and cyclical—and meanwhile LDCs continued to borrow. This would set the stage for the next crisis: debt. The IMF would eventually develop supplementary forms of borrowing resources to finance ever increasing needs by members. The discussions would center on the policies for this new financial intermediary role of the

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fund, and what the conditionality would be to ensure adjustment of the borrower to loan recovery by the lender. The Role of the LDCs and the G-24 During the Process of Monetary Reform (1972–1982)

During the process of monetary reform, the developing countries were able to achieve some institutional advantages, as well as the creation and enlarged use of financial mechanisms. This enabled these countries both to participate more actively in the workings of the system and to attempt to cope with the serious economic and financial difficulties of this period: monetary instability, economic stagflation, and the consequences of the energy crisis. During the early stages of the reform process, two subcommittees of the Committee of 20 had been chaired by distinguished developing country representatives: Frimpong Ansah of Ghana, for the group on transfer of real resources, and Alexandre Kafka of Brazil, for the group on convertibility and asset settlement. Ali Wardhana, minister of finance of Indonesia, chaired the Committee of 20 at the ministerial level. The Latin American countries had been active in promoting the study of international capital markets as part of the problem of the transfer of resources. A working group was created for this purpose, chaired by Alfredo Phillips of the Central Bank of Mexico. One of the main issues was the problem of access to long-term capital markets, not just the short- and medium-term commercial bank loans. It was novel that this group invited high-level market participants from investment banks, bond markets, and insurance company funds (to which access was very limited). Some of the working group’s recommendations proved quite enlightened as the debt crisis unfolded a few years later. Figures who were to become very important participated in sessions of that group, such as Jean Claude Trichet, future governor of the Bank of France, D. Weatherstone of Morgan Guarantee Bank, and Fred Bergsten. An important proposal by the developing countries was the creation of the Development Committee. The industrial countries and the IMF staff had advocated the transformation of the Committee of 20 into the Interim Committee to pursue negotiations and discussions on IMF-related monetary topics. This was also supported by LDCs. However, Ernesto Fernandez Hurtado, governor of the Central Bank of Mexico (and a deputy of the Committee of 20), considered it necessary to have a permanent institution to deal with the transfer of real resources to developing countries, which had had very unsatisfactory treatment in the reform process. It was considered that this could be a World Bank committee, but it was thought that the IMF also had to be involved in the issue. In addition the IBRD, led by

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A Quarter-Century of Experience

its president, Robert McNamara, had not been as close to the G-24 as the IMF. Therefore it was proposed that there be a joint committee. (The U.S. delegation viewed the proposal sympathetically, and it had also been strongly promoted by the Latin American delegations.) Thus the Development Committee was created. In the usual search for geographic balance M. Konan Bedie of Côte d’Ivoire was the first chairman, supported by the French, and Henry Constanzo, an American, its first executive secretary. Neither of them played a significant role, and the committee got off to a slow start. At a later meeting, in 1984, as deputy minister representing Mexico, I mentioned that the committee—with the world already immersed in the debt crisis—had not yet placed the topic of debt on the agenda. This seemed like the conditions in medieval Byzantium, where the sex of angels was being argued while the Turks were already at the gates. Fortunately, the subject of debt has since become established institutionally, though not at the same level of participation and importance as it had been with the Interim Committee. In the financial sphere, a wide array of policy instruments were created to tackle different problems and assist countries in diverse circumstances. Three basic periods of internationally distributed SDRs were issued, so that in 1982 holdings by countries totaled around 17 billion SDRs, out of which LDCs held around 4 billion SDRs. Quota increases in the IMF were also accomplished, and the fifth quota increase was particularly important. It was one of those few cases where concerted action by the LDCs almost blocked an international decision because the amount of the increase and its features had not been considered satisfactory. The oilexporting developing countries, whose influence had considerably increased, doubled their share in those quotas. The creation of the oil facility to finance the disequilibriums of the oil-importing countries was particularly important. Its appropriate philosophy, which was geared to the need to finance balance of payment deficits and prevent an undue adjustment in the initial stages of the crisis, has not been subsequently followed. The facility’s creation was also the last case in which both industrial and developing countries were interested in the mechanism, as potential debtors. Some major industrial countries also drew, for the last time, under regular facilities: the United Kingdom had a 24-month standby agreement for 3,360 million SDRs in 1977, the largest ever; Italy also had had a standby agreement. But these circumstances still gave the IMF a balanced, multilateral character. In addition developing countries also became creditors, particularly Saudi Arabia, Venezuela, Iran, and Kuwait. The participation of the oil countries in expanding supplementary lending to the IMF gave them substantial leverage: Saudi Arabia was to get the first additional chair on the Executive Board. In general, new financial facilities were established to draw larger amounts, for longer periods, and, in some cases, with greater flexibility.

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The extended fund facility was made greater use of, and Mexico and Kenya were the first to draw under it in 1976. The supplementary financing facility was established. The compensatory financing facility was adjusted and simplified to better take into account the shortfall of export earnings, but now also to include such services as tourism. The least developed countries received a subsidy account to obtain loans on more concessional terms. There was an interesting debate over the sale of IMF gold to obtain the resources to subsidize the least developed countries through a trust fund. The United States was particularly interested in selling gold, but other gold holders and gold producers were not. Once again the dividing line cut across developed and developing countries. France, Canada, Australia, and South Africa, but also Mexico and Argentina opposed the sale of gold. Finally a compromise agreement was reached whereby one-sixth of the fund’s gold (25 million ounces) was sold for the benefit of the developing countries, but another one-sixth was returned to the countries. The IMF became a significant lender of last resort. The Group of 24, as a coordinating body of the developing countries, played an important role in the preparation of these discussions. The G-24 would hold meetings, first between the G-9 executive directors and the senior officials (the deputies), and later the ministers would be informed of the issues and discuss them. As in the G-10, the deputies prepared their ministers. The UNCTAD and the IMF, and to a lesser extent the World Bank staff, provided technical background. Sometimes ministers who were newcomers to the meetings received surprises, because the strength and radicalism of some of the developing countries’ positions in the G-24 were weakened or diluted when confronted with the interests of the industrial countries. There was a Committee of 20 meeting in Nairobi, where a developing country minister, encouraged by the G-24 ministerial meeting, presented some unrealistic proposals, to be sharply rebuked, by then West German Finance Minister Helmut Schmidt, who said that the committee was a meeting of finance ministers, not a “Red Cross” assistance gathering. In general the communiqués, the end result of the ministerial meetings, became very lengthy shopping lists that reflected the concerns of every group of developing countries, by region and by level of development. This led to a loss of focus, which weakened the influence of the group. The G-24 prepared and presented three important documents, corresponding to periods of political and intellectual activism in which they were able to contribute significantly to the debate. Two of them relate more to international monetary reform issues and one to the debt issue (to which we will refer later).

The outline for a program of action on the international monetary system (August–September 1979). The “interim reform” had left many pending

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A Quarter-Century of Experience

issues, and there was a great deal of concern about the state of the world economy. In 1979 the IMF and IBRD annual meeting was going to be held in Belgrade; Yugoslavia was both an active member of the G-24 and a leading country of the G-77 (Marshal Tito, though then ailing, had a unique historical position of leadership among developing and nonaligned countries). It was possible to convene for the first time a meeting of both ministerial groups. The G-77 had previously met in Arusha, Tanzania, and had put forward a number of proposals in its final declaration. Mexico held the chairmanship of the G-24. It had overcome its difficulties of 1976, had emerged as an important oil-exporting country, had a strong economy, and was able to play an active and leading role. Alfredo Phillips convened the “bureau” (the G-24 body consisting of the chair, vice-chair, and second vice-chair) to work in Mexico City, in the offices of the Central Bank, and later on in Belgrade. A number of senior officials worked enthusiastically, including Gayra Popovi ´c of Yugoslavia and a group of Mexican officials—Salvador Arriola, who later became secretary general of SELA, Ariel Buira, and myself. The work of the developing country officials proved to be the main driving force for the elaboration of “the outline,” although this outline was supported by the UNCTAD staff, particularly S. Dell, who had prepared good technical papers.3 The basic point of the report was that the expectations for improvement in the world economy after the Jamaica accords had not materialized, nor had adequate progress been reached “in the workings of the monetary system.” Instead, a number of problems were prevalent: “the problem of stagflation of developed countries [proving] to be more intractable,” “violent swings in exchange rates,” “lack of policy co-ordination among major economies,” “a rising wave of protectionism,” “adverse terms of trade,” and declining volumes of official development assistance (ODA). Hence there was the need to establish a mutually supporting action in trade, development finance, and “monetary arrangements.” This important triangular comprehensive approach would be a feature of the G-24 view.4 The proposals had two components. On the one hand, the developing countries reiterated their common interest in pursuing international monetary reforms, within the overall context of a new international economic order. This part of the document reiterated support for an effective, symmetrical, and equitable adjustment process with IMF surveillance; the need for stability in exchange markets and the creation of international liquidity through collective action, with the SDR as principal reserve asset; the promotion of net flows of real resources; and a greater role in decisionmaking for developing countries. On the other hand, the program of immediate action contained a number of proposals in different areas: • Measures to promote the transfer of resources including an increase in the quantity and quality of ODA, the link (of SDR to increased

The Developing Countries and the International Financial System

15

ODA), larger program lending by the IBRD, replenishment of International Development Association resources, and increased capital to the IBRD • Increases to total reserves, through the seventh review of quotas and new SDR allocations • Measures related to balance-of-payment support, including a medium-term balance-of-payments facility, the review of existing IMF facilities, and their conditionality • Measures related to trade, including adherence to stand-still provisions pledged by developed countries (not to increase protectionism) and a new World Bank long-term facility to finance purchases of capital goods by LDCs, ensuring appropriate additionality of resources

The outline of a program of action was launched in Belgrade, with substantial political fanfare at the joint G-77 and G-24 ministerial meeting that approved the program. Although specific actions could not be adopted, the developing countries did take the political initiative, surprising the international organizations and industrial governments with reasonable and technically well-sustained proposals, including the adoption of the cause of advancing the reform of the system. It showed the advantages of reasonable economic “activism.” However, some of the more radical and less feasible proposals of the Arusha declaration of the G-77 were turned down by the G-77 and G-24 finance ministers and central bankers.

The revised program of action of the G-24 (adopted in September 1984) and the report on the functioning and improvement of the International Monetary System (October 1985). As the debt crisis unfolded, the G-24 as such would play a less important role than it had in the reform process of the 1980s, but there was still another important attempt at advancing the discussions on monetary reform. In September 1984 the G-24 had approved a revised program of action. However, after September 1983, as one of the consequences of the Williamsburg, Virginia, summit, the G-10 had asked their deputies to prepare a report on ways to improve the system. That report was concluded in the summer of 1985 and presented to the consideration of the Interim Committee. The G-24 also asked a group of experts to elaborate a report on the functioning and improvement of the international monetary system. This report was approved and was also presented for submission to the Interim Committee at its meeting of October 1985. So, both the G-10 and the G-24 reports were analyzed by both the Executive Board of the IMF and the Interim Committee. Obviously there had been some progress since the onesided presentations of 1972, when only G-10 proposals had been discussed. It may come as no surprise that the G-10 deputies “expressed complacency about the workings of the present system, and that it did not require

16

A Quarter-Century of Experience

fundamental changes.” However, the G-24 expressed dissatisfaction with the system and the need for reform. It is interesting to compare how both documents approached the main issues.5

1. As for the exchange rate systems, both documents agreed that a return to a system of par values was not feasible. The G-24 attached more importance to the need for a greater degree of stability and had sympathy for a system of target zones. This was rejected by the majority of the G-10. However, a few months later the Louvre Accord of 1987 tended to prove that the G-24 view was realistic. 2. In regard to IMF surveillance, the G-10 took the view that no major changes were required, although some specific procedural suggestions were made about the Article IV consultation process. The G24 took the view that IMF surveillance had been very ineffective with the major industrial countries. The adjustment process had thus been asymmetrical and the burden was too heavy on the developing and smaller countries. It also took the view that there was generally very inadequate coordination of macroeconomic policies. 3. On the management of international liquidity, there was agreement by both groups that the floating rate system had not led to a decline in global demand for reserves The G-10 report highlighted the role played by the international capital markets in providing international liquidity, and obviously showed no agreement on the future role of SDRs as well as future issues. The G-24 supported the SDR as the future main resource asset and the need to make new issues. It also held the view that fund quotas had been declining in terms of imports. 4. There were important differences over the future role of the IMF. The G-10 was concerned that the role of the IMF should not be confused with a development-finance institution, since the IMF was lending more and for longer periods. The G-10 supported the revolving character of fund resources and its use as a temporary support mechanism. 5. The G-24 expressed its view that the fund was not playing its role because of inadequate surveillance of major countries, the inability to provide the system with liquidity through SDRs, and with the lagging of the level of quotas behind requirements. The G-24 questioned the conditionality approach for placing too much reliance on demand restriction. 6. The G-10 report did not deal with the already serious international debt crisis. The G-24 made an in-depth analysis of the crisis’s causes and proposed means to increase the transfer of real resources.

The Developing Countries and the International Financial System

17

The Lost Decade of the Debt Crisis, and the Dwindling Role of the G-24 (1982–1992)

A well-balanced analysis of the debt crisis has been difficult to achieve. Some place more blame on the international factors, others on the policy errors of individual countries. The G-24 certainly participated in this debate. One of its documents quotes an excellent paper by W. Cline: “It is difficult to believe that more than 30 developing countries simultaneously went on a binge of fiscal irresponsibility. A far more reasonable hypothesis is that their similar and contemporaneous balance of payments problems were the result of a common external source, international economic disruption.” At any rate, the debt problem was both to plague and overwhelm the period 1982–1992, but, in general, the G-24 as such played a much less active role. The main players were the key debtors, acting largely in isolation. With the benefit of hindsight it is unfortunate that the G-24 could not do more at a political level. In fact the debt crisis had a number of causes, some of them external to the developing countries and some of them of the countries’ own making. The oil price increases had provoked abrupt and massive swings in balance-of-payment positions and huge shifts in the accumulation and allocation of savings throughout the world economy. The large petrodollar flows were recycled to industrial and developing countries alike through the commercial banking system. When the industrial countries initiated their adjustment process and real interest rates increased, the developing countries were caught by a vicious circle of widening balance-of-payment deficits, increased borrowings with higher real costs, and reduced demand and adverse terms of trade for their exports. Mexico, which detonated the crisis in August 1982, illustrates these general points. It had been growing at rates over 7 percent due to higher oil exports, increased foreign borrowing, and foreign investment flows. It also was running a 16 percent of GDP fiscal deficit in 1982. External borrowing had been obtained at a rate of about $2 billion per month. When commercial banks finally noted the problems of the underlying indicators, and the demand and price of oil exports had fallen, commercial banks “overreacted,” turned off the credit faucets, and precipitated the beginning of the debt crisis. The debt crisis had several phases, which are discussed below.

Stage I: Temporary Liquidity Problem; Refinancing the Debt (August 1982 to September 1985)

Initially it was considered that the debt problem was a temporary liquidity problem. Countries needed to gain time, and to obtain some “fresh money.” Hence most of the debt negotiations in this period led to multiyear

18

A Quarter-Century of Experience

restructurings on the old money and new credits to keep the country going. Debt was a particularly important problem in the Latin American countries. At the Cartagena, Colombia, meeting of finance ministers of that region, the world financial community was still very ill prepared to cope with the crisis and was genuinely scared that Latin America could achieve a coordinated strategy to obtain better terms, including a possible moratorium of payments as a negotiating instrument. But, as would occur often throughout the process, countries were always at different stages of their negotiation, with different underlying economic and debt conditions, different expectations of the conditions that they would obtain, and different assessments about the costs and benefits of concerted actions. They did not take “the step.” However, the industrial countries, now given the necessary time, were indeed able to evolve a concerted strategy. Stage II: ”Growing” Out of Debt with Structural Policies: The Baker Plan (September 1985 to 1988)

By 1985, it was clear that debt was not a short-term liquidity problem and that several developing countries were in fact getting into more serious difficulties; the new resources were simply “ballooning” the new debt service with the old one. Mexico, again a typical case, had to present in mid1985 the threat of a “silver bullet”: it would continue debt service, but frozen in peso accounts if new approaches were not adopted. However, the Mexican government had become convinced that acting solely on demand management was not enough and that it had to undertake actions on a broad front: rationalize the size of the state and open the economy to trade and competition and to direct investment flows. U.S. Treasury Secretary James Baker launched his plan in September 1985, at the annual meeting in Seoul, acknowledging that countries had to grow out of debt. The new strategy, however, also entailed that countries did not only require demand adjustment measures but structural change as well. This started a new era of very complex relationships between debtor governments, commercial banks, and the international financial institutions. Conditionality became “cross-conditionality.” The financial packages involving the IMF, the World Bank, and the commercial banks had to be implemented with various players playing the right tune and in unison. The IMF had to certify sound demand management and monetary, fiscal, and exchange rate policies. The World Bank had to support structural changes in trade, the public sector, and foreign investment. Then the commercial banks could extend payment periods, reduce spreads, and provide new money, together with the Bretton Woods twins. As a novel feature, contingency triggers were built in to ensure growth. For example, in the case of Mexico if the price of oil fell below a certain level, and growth recovery did not materialize, new resources could be provided.

The Developing Countries and the International Financial System

19

Recognition of the Debt Overhang and the Provision of the Debt Reduction Menus; the Brady Plan (March 1989 to 1992)

By the end of the decade, it was clear that the 1980s were a lost decade for the developing countries. Countries had not grown out of debt; in fact the debt overhang, in spite of the adjustment efforts, had been asphyxiating the growth possibilities of the indebted countries. In March 1989 U.S. Treasury Secretary Nicholas Brady announced a new initiative. For the first time, a plan recognized that there was a problem of a debt “overhang,” and that there was a need to introduce elements of debt reduction. This would have been unheard of some years earlier. The plan had some important additional features, The new arrangements had to be the result of voluntary negotiations between commercial banks and debtor countries, in a market-based, case-by-case approach, and the affected countries would have to be in the process of introducing substantial structural policy reforms. Essentially, old debt was exchanged for new long-term debt, with a lower face value. Normally this new debt was guaranteed by 30year zero coupon Brady bonds. The commercial banks and the World Bank developed a “menu approach” to offer different variations of the scheme. Mexico and Costa Rica were the first countries to achieve a broad agreement, followed by Venezuela and Uruguay. In 1990, the G-24 produced another well-thought-out document analyzing the situation in which the developing countries found themselves in the aftermath of the Brady initiative.

The Role of the IMF and the World Bank in the Context of the Debt Strategy: The G-24 View (August 1990)

Again, the G-10 had asked its deputies to produce an assessment of the role of the IMF and the World Bank in the context of the debt strategy. This document was completed in June 1989. In turn, the G-24, now under the chairmanship of Iran, asked its deputies and executive directors to prepare a report on the same topic. This was submitted to the ministers of the G-24 in September 1990. Besides presenting its own proposals, the document provided good technical counterarguments and very often effectively rebutted the G-10 document.6 As in 1985, the G-10 document’s motivations were quite different from those of the developing countries: the two basic concerns of the industrial countries were, first, that the IMF and World Bank were being driven by the debt crisis away from their traditional areas of responsibility and expertise, with some substantial areas of overlap. Second, the institutions were acquiring an increasing share of liabilities of the indebted countries. As in the previous report, the keynote was complacency about the appropriateness of the several approaches taken on the debt strategy, with no attention drawn to limitations, setbacks, or new policies.

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A Quarter-Century of Experience

The G-10 argued that while there was a need for the IMF to maintain a central role in the debt strategy, it provoked concern that the IMF’s essential nature was to give balance-of-payment assistance on a temporary basis while preserving the revolving character of its resources. These issues would be kept under continuous review by the G-10 members. In regard to the World Bank, its nature was defined as its orientation toward project-based finance and the need to safeguard its standing in the capital markets. Hence there had to be a limit on the resources available for policy-based lending. The debt problem had unfolded into a fully global problem. As the G24 report emphasizes, between 1985 and 1990, seventy developing countries had increased payment arrears or entered official or commercial bank debt-rescheduling agreements; the World Bank had identified no fewer than 46 countries as severely indebted. The external debt of developing countries had increased from $840 billion in 1982 to $1.3 trillion at the end of 1989. The G-24 report therefore highlights the continued seriousness of the debt crisis. It also welcomes the new approach of the Brady plan to debt reduction and relief. It accepts the need to undertake “serious dramatic macroeconomic and structural adjustments” while rejecting the G-10 view that the crisis arose solely because of inadequate economic policies. It emphasizes on its part the unfavorable world environment and the effect of exogenous causes beyond the countries’ control. However, while accepting the need for coordination between the two Bretton Woods institutions, the report rejects the G-10 proposals for more formalized cross-conditionality and uniformity of views on policy matters in country programs. The G-24 report also points to the problem that official debt has been increasing very rapidly as a share of total debt due to the reduced flows from private resources. It distinguishes between adjustment to keep servicing a debt overhang from adjustment to generate future growth. It rejects the G-10 view that conditionality is “rigor” for its own sake, and argues that “relevance,” “feasibility,” and “appropriateness” are the correct criteria to assess conditionality. It also opposes the view that the international debt problem is just a collection of specific-country problems. Finally, the G-24 argues that the roles of the IMF and World Bank have evolved from the need to deal with the crisis, and therefore it is inadequate to attempt a “legalistic” approach to define excessive demarcation lines. It recalls that the primary role of the IMF and the World Bank is to assist members in achieving sustainable growth and that governments must retain primary responsibility in designing and implementing their policies. As in 1979 and 1985, the document of 1990 contains a well-reasoned framework to support the technical and political positions of the developing countries and deserves to be among the intellectual highlights of the

The Developing Countries and the International Financial System

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work of the G-24. It is, however, an exception to the view that in the period of the debt crisis the G-24 did not perform the more active role that it had in the period of the monetary reform process. From Growth Renewal Optimism to the First Crisis of Globalization of the 21st Century and the Asian Crisis: From Penance and Fruition to Miracles and Mirages (1993–1997)

“Between 1990 and 1993, net private capital flows to developing countries are estimated to have risen from $43 billion to $113 billion, and in 1992–1993, these flows were larger than the official flows for the first time in a decade.”7 This was an essentially positive indicator, perhaps pointing to the end of the debt crisis process. In these two years, the developing countries grew by 5.6 and 6.0 percent, although this average is heavily influenced by the performance of a few countries, mainly Asian (Africa’s growth was still –6.0 and 1.9 percent and Latin America’s, 2.6 and 3.8 percent). In the aftermath of that “lost decade” for development, there were some features in the world economy that gave grounds for optimism in the early 1990s:

• The extraordinary growth performance of the United States, driving the world economy forward • After Maastricht, the very serious drive in economic policy convergence and stability objectives of all the European economies in the path to the euro • The progress made by the so-called transition economies toward a market system, and the notable economic success of countries such as Poland, Hungary, and, to a lesser extent, the Czech Republic, and the impressive growth and changes in the Chinese economy • The acceleration of interdependence and globalization in the areas of trade, investment, and technology transfers • The worldwide consolidation of democratic regimes

A noteworthy trend in evidence among all the major economies, whether industrial, transition, or emergent, was the convergence in macroeconomic policies and the structural reforms along basically the same lines of action. For many developing countries the adjustments to the energy crisis, the debt crisis, and the increased competition in a global world had them start the 1990s with the achievement of an impressive record of reforms. Those policy changes have been summarized in the so-called Washington

22

A Quarter-Century of Experience

consensus list. It is not relevant here to argue whether these reforms were “endogenously” determined by the countries themselves or “exogenously” imposed by the international organizations, creditor governments, or world conditions. In varying “mixes” in different countries there were elements of both. However, what is important to analyze is the degree of success and the consequences of the different reforms. There is the first group where convergence is almost unquestioned and where results have been positive: the move toward reduction of public deficits to below 3 percent of GDP, the primary responsibility of monetary policy to achieve price stability and reduce interest rates, or the tendency toward trade liberalization to make economies competitive. There has been, however, a great deal of debate over the “standard recipes” implicit in other Washington consensus “commandments,” such as the use of exchange rate policy as the nominal anchor to bring down inflation, the process of financial liberalization, and the characteristics of foreign capital flows (short-term financial versus direct investment). These last three policy elements of the “reform package” have been subject to revision because of their role in the Mexican and Asian crises. The optimistic view that developing countries were on the path to sustained growth, after having followed the standard reform package, was subject to doubt in light of the Mexican crisis of December 1994, called by Michel Camdessus the first crisis of globalization of the 21st century. Mexico’s structural reforms had just prior to the crisis been hailed as an outstanding example, and the underlying fundamentals had been considered satisfactory because the public sector was running a surplus. Also, that success and privatization had attracted significant capital inflows, but the current account deficit had risen to around 8 percent of GDP, with short-term flows maintaining a stable nominal exchange rate. But once the Mexican peso was declared “overvalued” (which is still subject to debate) and the current account “unsustainable,” massive outflows triggered the crisis. Corrective actions required a fall in GDP of 6 percent in 1995 and millions of people being unemployed. The cost of the ensuing bank crisis, after what had been considered a successful financial liberalization, has now reached 15 percent of GDP. After considerable hardship, the Mexican economy has recovered its growth rates, exceeding 6 percent. At the same time, the development of the Asian Pacific economies were receiving increased attention as the models to follow. The World Bank published its findings in a book, The Asian Miracle. These countries had, unlike Mexico, as it was pointed out, high levels of savings and sound investment, development of human resources, efficient export-oriented industrial conglomerates, and good development-oriented governance. In 1997 the Asian crisis erupted. Many of its features were a repetition of the Mexican crisis. The “market” abruptly turned “miracles” into

The Developing Countries and the International Financial System

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“mirages.” Again, the affected countries had most of their economic fundamentals in good order, and IMF reports had praised them. Large capital inflows had appreciated some of the exchange rates in real terms. Some (e.g., Thailand) had large current-account deficits; many Korean and Indonesian private companies had received excessive short-term loans. But most countries had undertaken financial liberalization under pressure from Western institutions. The difficulties of one country, or one conglomerate, then spilled into the others. Again, credit faucets were closed abruptly, and a serious exchange rate depreciation followed. Dramatic economic adjustments in the affected countries have begun under programs supported by the international institutions. But the trail of social misery has started in countries that do not have developed safety nets. The cause of the above problem is found in inadequate structural policies of the countries, corporate governance, unsound relationships between banks and industrial groups, poor banking supervision, and lack of transparency of information (a problem also mentioned in Mexico). Nobody has referred to bad creditor analysis using some rather evident published information. The IMF has been entrusted with overall responsibility for management of the crisis. It has suffered increasing criticism, not from left-wing radicals but from quite well-known economists like Martin Feldstein and Jeffrey Sachs. The criticism relates both to the “one size fits all adjustment measures,” including greater fiscal and monetary restraint for countries that had sound fundamentals in this area and to inadequate advice on structural changes. There is reluctance by industrial countries and some multilateral organizations to accept that “global financial markets” may not be functioning adequately and that the burden of adjustment is unjustly shared. There was the same initial complacency at the beginning of other crises. It is clear that “moral hazard” and free riders are rampant. The private-sector “fundamentals” in institutions of developed, as well as developing, countries should be examined. The IMF is perhaps embarking on widespread capital-account liberalization in not the best of circumstances, when the necessary preconditions are not yet ready. The Mexican and Asian situations point to a “systemic” malaise. Where will the next crisis occur? There is a need for the G-24 to review again how the IMF and the World Bank function. Both have radically changed their functions, becoming institutions to watch over and finance developing and transition economies—functions that have not been adequately performed. Surveillance has not led to crisis prevention; financing of last resort has not been sufficient to avoid undue social pain. For the IMF, the temporary balance-of-payment adjustment assistance and the revolving character of its resources is very much in question. The World Bank has specialized more in structural policy changes and increasingly in

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A Quarter-Century of Experience

social compensation policies to mitigate adjustment, with special emphasis on poverty alleviation. Its initial role of financing projects has long been dwindling. The agenda has changed radically to deal with issues of governance, corruption, and social policies, issues that may dangerously impinge on the legitimate domain of national governments and sometimes serve as tools of nongovernmental organizations of questionable purposes and motivations. In such a setting it is very opportune that the Venezuelan government, in again assuming the chairmanship of the G-24, after 25 years, has adopted a number of initiatives to boost political and economic cooperation among developing countries to support them in playing an active role in responsible international debate on issues that threaten the stability of the world economy and social cohesion within countries. Finally implementing the long-debated proposal to have a permanent secretariat is a very important step. Focusing on the main world issues, as shown by the agenda presented in the Caracas Declaration of February 1998, goes well toward rekindling the intellectual and political stamina of the Group of 24 that had started to produce results for the benefit of developing countries when the group was created. Notes

I would like to express my appreciation to Christian Brachet, Ariel Buira, Javier Guzman, Roberto Marino, Jesús Cervantes, Gerardo Lozano, and Norma Pensado for their help in obtaining valuable research materials. The responsibility for the ideas expressed in this chapter is of course my own. 1. Proceedings and Discussions of the UN Monetary and Financial Conference, vol. 2 (U.S. Department of State, 1948), 1176. 2. This section on SDR negotiations relies on the excellent review by Randall Henning, The Group of 24, Two Decades of Monetary and Financial Co-operation Among Developing Countries, 138–140. This work is extremely useful in following the history of the G-24. 3. Ibid., 149. Henning recognizes the technical work of the experts, but in my view misses the point that the deputies and senior officials played the leading political role and also in a major way integrated the technical work. 4. Outline for a Program of Action of International Monetary Reform, 1979. 5. For the presentation of these reports I summarize the excellent paper by Ariel Buira, “El funcionamiento del Sistema Monetario Internacional,” Propuestas de Reforma por el G-10 y el G-24. Trimestre Económico (Mexico, OctubreDiciembre 1986). 6. The G-24, the role of the IMF and the World Bank in the context of the debt strategy. Report to the Ministers, August 1980. 7. M. Moussa et al., “Improving the International Monetary System, Constraints and Possibilities,” IMF Occasional Paper 116 (Washington, D.C.: December 1994), 14.

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Bibliography

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Aglietta Michel. “Cinquante ans après Bretton Woods.” Economica, Paris (1994). Banco de Mexico. “El Grupo de los 24: Evolución y Perspectivas.” XXIX Reunión de Gobernadores de Bancos Centrales Latino Americanos, Madrid (Septiembre 1979). Boughton, James M., and Lateef, Sarwar, eds. Fifty Years after Bretton Woods: The Future of the IMF and the World Bank. Washington, D.C.: IMF, World Bank Group, 1995. Buira, Ariel. Reflexiones sobre el Sistema Monetario Internacional. Mexico: CEMLA, 1994. Buira, Ariel. “El Funcionamiento del Sistema Monetario Internacional.” Propuestas de Reforma por el G-10 y el G-24. Trimestre Económico, Mexico (OctubreDiciembre 1986). De Vries, Margaret Garrison. The IMF in a Changing World, 1945–1985. Washington, D.C.: IMF, 1986. Development Committee. Communiqués 1975–1997. Development Committee. Developing Country Access to Capital Markets. Washington, D.C., 1978. Frenkel, Jacob, and Goldstein, Morris, eds. International Financial Policy: Essays in Honor of Jacques Polak. Washington, D.C.: IMF, 1991. Frenkel, Jacob, and Goldstein, Morris, eds. Functioning of the International Monetary System. Washington, D.C.: IMF, 1996. G-24. “Outline for a Program of Action of International Monetary Reform.” August 1979. G-24. The Role of the Fund and the World Bank in the Context of the Debt Strategy, Report to Ministers. August 1980. Group of 24. Communiqués 1972–1997. Gwin, Catherine, and Feinberg, Richard. Pulling Together: The International Monetary Fund in a Multipolar World. Washington, D.C.: Overseas Development Council, 1989. Henning, Randall. The Group of 24, Two Decades of Monetary and Financial Cooperation Among Developing Countries. IMF. Annual Reports. IMF. International Financial Statistics. Interim Committee. Communiqués 1975–1997. Lateef, Sarwar. The Evolving Role of the World Bank: Helping Meet the Challenge of Development. Washington, D.C.: World Bank, 1995. Mussa, Michael, Morris Goldstein, Peter Clark, Donald Mathieson, and Tamim Bayoumi. “Improving the International Monetary System, Constraints and Possibilities,” Occasional Paper 116. Washington, D.C.: IMF, 1994. Suárez Dávila, Francisco. “La Política Financiera Internacional de Mexico, Relaciones con el Banco Mundial y el FMI.” Comercio Exterior (Octubre 1994). Ul Haq, Mahbub, Richard Jolly, Paul Streeten, and Khadija Haq. The U.N. and the Bretton Woods System 1995. UNCTAD. “The International Monetary and Financial System, Developing Country Perspectives. Proceedings of a Conference Sponsored by the G-24 on the Occasion of the Fiftieth Anniversary of the Bretton Woods Conference. Cartagena, Colombia, April 1994.” In International Monetary and Financial Issues for the 90s. Research Papers for the Group of 24. Zalduendo, Eduardo. “A Brief History of the Group of Twenty Four.” Mimeo (1986).

2 The Future of the Group of 24 Aziz Ali Mohammed

The Group of 24 on International Monetary Issues (G-24) met for the first time in formal session in Caracas, Venezuela, in April 1972. The three countries constituting the “bureau” on that occasion were Venezuela (chair), Algeria (first vice-chair), and Sri Lanka (second vice-chair). The G-24 met in extraordinary ministerial session in February 1998 in the same city and, by a strange coincidence, with precisely the same configuration of the three chair countries.1 What distance the G-24 has traversed in a little more than a quarter-century of its existence might provide some indications of its future. Three issues appear to have been common to the two meetings. The first issue was a strong dissatisfaction with the working of the international monetary system (IMS) and with the procedures for arriving at decisions on international monetary matters. At the earlier meeting, the chairman had observed that a simple agreement reached by a small number of developed countries had changed basic relationships in the monetary area. The developing countries were dissatisfied with this arrangement and were resolved to establish “a viable counterpart to participate more effectively in the defense of their common interests.”2 They proposed the establishment of a committee to consider reform of the IMS. The declaration—Caracas II—issued at the conclusion of the 1998 meeting, saw “an urgent need for a wide-ranging review by a Task Force comprising industrial and developing countries” of a number of issues, among them the need for “increased representation and participation of developing countries in the decision making organs of the international community.”3 A second issue was the system for determining IMF quotas. The 1972 meeting had stated that the “present system . . . does not reflect the relative economic position of Fund members”; the 1998 declaration noted the need to “properly reflect the developing countries’ growing influence in the world economy.”4 A third common issue related to the SDR. The 1972 meeting had supported the proposal for the activation of the SDR mechanism and urged for 27

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the creation of a link between SDRs and additional development financing, but the 1998 declaration agreed “to support an expanded role for the SDR in the international monetary system.” The commonality of the three issues, however, concealed significant differences. The decisionmaking issue in the 1972 meeting, for instance, was concerned exclusively with the IMF and the reform of the system, making specific reference to proposing “necessary amendments” to its statutes. The 1998 declaration speaks of the “decision making organs of the international community,” thereby pointing to the broadening of the scope of interest beyond the IMF to include not only the World Bank Group and its regional counterparts, but also other international organizations such as the World Trade Organization (WTO). Similarly, the reference in the 1972 communiqué to the determination of IMF quotas had been widened to cover “the bases for determining voting power in international financial institutions” (author’s emphasis). Although the 1998 reference to the SDR is cast in general terms, there is no mention of the “link” that featured so prominently in the 1972 and subsequent G-24 communiqués but that was finally buried in 1985. Behind the 1998 reference to the link, however, there lies a certain amount of research, done under the auspices of the G-24 research program after 1995 and resulting in proposals whereby the developing countries would themselves take tangible steps to support the SDR mechanism and broaden the functionality of the SDR by making it possible to trade SDR certificates on international financial markets. These significant differences point to the G-24’s interest in strictly monetary (and therefore IMF-centered) issues expanding to those relating to development finance (hence the World Bank Group and the regional development financial institutions). More recently concerns associated with private financial flows and capital markets have been added to the G-24 agenda, as indicated by the Caracas Declaration II. However, these issues do not exhaust the main changes that have taken place and that are germane to projecting where the G-24 is, or should be, headed. Changing Content of G-24 Work (1994–1997)

The substantive work of the G-24 has been reviewed on several occasions, and two of the reviews were published in 1986 and 1992.5 Rather than repeat their evaluations, more recent activity will be discussed here, including in-house reviews, demonstrating the manner in which thinking about the role and function of the G-24 has been evolving since 1994—when the celebration of the 50th anniversary of the Bretton Woods institutions (BWI) gave a powerful impetus to reappraising the functioning of the G-24.6 The internal reviews began with a decision by the ministers at their April 1994 meeting to establish a Special Working Group (SWG) under

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the Guatemalan chair “to assess the role of the G-24, to examine and review the effectiveness of the operative mechanisms of the G-24 and to suggest measures and actions . . . to enable the G-24 to achieve the objectives for which it was set up.” The SWG reported in August 1994, and on the basis of its recommendations a resolution on the “Operational Mechanisms of the Group of Twenty Four” was adopted by the ministers at Madrid on 1 October 1994.7 In discussing the mandate of the G-24, the SWG noted that the broadening of the G-24 agenda was a natural consequence of the evolution of the work of the BWI, as reflected in the agendas of the Interim Committee and Development Committee. It noted that the IMS itself had grown outside its conventional official framework into a market-dominated “nonsystem” in which private capital flows, transnational corporations, and regional trade arrangements had assumed importance. The explosive growth of “service” sectors underlined the significance of issues like “rights of establishment” and migration as integral elements in the globalization of factor markets. Intellectual property protection had serious implications for developing countries, as did the application of environmental and labor welfare standards to the developing countries’ exports and the growing practices of contingency or procedural protection. While noting the necessity for broadening its mandate, the SWG cautioned against a proliferation of issues and argued in favor of carefully selecting items for inclusion in its public pronouncements. This caution did not apply to the G-24 Research Program.8 In addition to examining issues on the (current or prospective) agendas of the Interim Committee and Development Committee, the SWG thought it important to consider other issues of special relevance to developing countries. These issues could be examined through research studies and discussed by a technical group from member countries that would review the studies and draw out their policy implications. The recommendation of the SWG was accepted by ministers at their October 1994 session, and a Technical Group (TG) has since become an active link between the output of the Research Program and its political audience, with the conclusions of the TG being increasingly reflected in G-24 communiqués. The contributions to the funding of the program that have begun to be made by G-24 members, and a few other developing countries, since 1995 have permitted a greater degree of flexibility in the choice of assignments; for example, it has been possible to prepare shorter position papers on topics of special interest to G-9 directors.9 Current Status of Unresolved Issues

Some other subjects raised in the SWG report have taken longer to be settled, or have yet to reach closure. The first subject relates to the size and

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composition of the G-24. The immediate issue was to find a replacement for the Federal Socialist Republic of Yugoslavia, which had ceased to be a member of the international community. A longer-term issue is whether the G-24 could be enlarged to reflect changing circumstances since the G-24 was formed, that is, to accommodate areas that were not yet officially recognized states, or were not representative of the majority of the population, or were assuming active roles in the developing world as “emerging markets.” The choice of new members remains unsettled, beyond an agreement that (1) any enlargement should preserve balance among the three regions, that is, Africa, Latin America, and Asia (including the Middle East), and (2) any enlargement should respect the principle of groupwide consensus. A second question raised by the SWG was how to enhance the continuity of the G-24’s operations, given the G-24’s tendency to hibernate between its two regular meetings in the spring and fall of each year. The SWG proposal to set up a small technical secretariat that could provide a focal point of contact the year round met with initial resistance from members fearful of spawning a new international bureaucracy and apprehensive about the costs of funding the enterprise. In September 1996 it was agreed, however, to authorize the establishment of an “experimental” office, located at BWI headquarters, with no more than two professionals appointed by the chair and first vice-chair countries, and with the IMF and World Bank Group requested to assist with office accommodations and secretarial support, respectively, during the experimental phase. The experimental office started work in March 1997, and at their extraordinary meeting in Caracas, in February 1998, the ministers put the office on a regular footing and decided to levy an annual fee for the office’s expenses. Relations with Other Groupings

A major subject that has a direct bearing on the future of the G-24, and has been a subject of much past discussion, relates to the relationships of the G-24 with the following actors in the international arena:

1. Executive directors (EDs) representing the developing countries on the executive boards of the IMF and the World Bank Group (referred to as the G-9)10 2. Other groupings of developing countries, including the Group of 77 (specifically, the office of the G-77 chairman at the United Nations in New York), the Group of 15, the South Center in Geneva, the Non-Aligned Movement (NAM) secretariat, and so on 3. Organizations in the UN system, specifically, the UN Conference on Trade and Development (UNCTAD) and the UN Development Programme (UNDP)

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4. Nongovernmental organizations (NGOs) taking special interest in monetary and financial matters affecting developing countries, for example, Eurodad, Fondad, and Oxfam International 5. Industrial countries

Relations with G-9

It had been customary to look toward G-9 EDs for supporting the work of the G-24. While this help had been characterized by the SWG as “unstinting,” the EDs’ preoccupation with their own regular duties meant that the G-9 could spare time and energy for the work of the G-24 only in the periods immediately preceding the ministerial meetings, and the EDs tended to focus on issues on the agendas of their respective institutions. With little prospect of global negotiations to reform the international monetary and financial systems, much of the work of adapting the system to changing international conditions had gravitated toward the BWIs. At the same time, the mandates of the Washington-based agencies were gradually stretched to include, inter alia, crisis management, protection of the environment, the fostering of private sectors and of market orientations in developing and transition economies, and issues of “good” governance. The G-9 EDs had thus taken on a pivotal role in formulating common positions that was previously performed to some extent by the G-24 in a context in which consideration of issues was diffused over many institutional forums, especially those operating under the UN system. It was thus natural for ministers to turn to their representatives in the BWI—engaged as the latter were in the day-to-day work of system management—to reach agreements among themselves and with their industrial country interlocutors on monetary, financial, and related issues.11 In this changed context, it became essential to ask not how the G-9 should be helping the G-24, but rather how the G-24 and its research program could strengthen the hands of the G-9 EDs. An answer to this question is central to the future role of the G-24 and is discussed in the concluding section.

Relations with Other, Developing-Country Groupings

The ministerial resolution of October 1994 charged the G-24 with cultivating relations with other developing-country entities in the interest of preventing duplication of effort and influencing diverse segments of national administrations with which some of these other groups might be more closely aligned. The relationship with the G-77 was somewhat ambiguous. In historical terms, the initiative for the creation of the G-24 originated with the G-77.12 However, the tendency over the years has been for the G-24 to act autonomously in order to maintain credibility as an expert group of financial officials, working on issues relating primarily to the work of the BWI. The assertion of autonomy has extended to the point of

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refusing to treat G-24 membership as a subset of that of the G-77, maintaining Mexico as a member in good standing despite its having joined the Organization for Economic Cooperation and Development (OECD). This departure from the G-24’s historical moorings has a bearing on a much larger question, namely, whether it remains appropriate to maintain separate identities for groupings like the G-24 when some of its members move to join, or aspire to join, industrial-country groupings. This issue is left to the concluding section of this chapter. Other groupings of developing countries have also emerged since the founding of the G-24. Ten members of the G-24 have joined with seven nonmembers to constitute a new Group of 15,13 with the purpose of pooling “their collective intellectual resources to work out coherent strategies of response which will ensure more efficient and equitable management of the global economic system.”14 While the G-15 has a foreign ministry locus of support, the fact that its plenary meetings take place at the level of heads of state or government means that finance ministries are involved in its deliberations. More recently, the G-15 has sought direct contact and participation of ministers of finance and central bank governors to discuss issues arising in the wake of the East Asian crisis. The manner in which the G-24 will coordinate its efforts with those of the G-15 remains an open question. Relations with UN System Agencies

As noted earlier, agencies within the UN system have directly supported the work of the G-24. For almost a decade following the establishment of its research program, the UNDP provided funding for the research program, which was directed by Sidney Dell after his retirement from the UN Secretariat. This support was terminated because of the UNDP policy of not becoming a permanent source of financing for any specific project. Following its withdrawal, three industrial countries that had previously contributed to the UNDP project—Canada, Denmark, and the Netherlands—continued their support on a bilateral basis, and this support continues to this day. Their contributions are deposited into a trust fund administered by UNCTAD in Geneva. The support of UNCTAD is historically rooted in its mandate to assist with developing world issues, although its specific responsibilities in the areas of debt and finance have been contested from time to time by industrial countries. This has not kept UNCTAD from its steady support for G-24 activities and by the presence of the UNCTAD secretary general or his immediate deputies at virtually every meeting of the G-24 ministers. The evolving role of the WTO suggests that it will share with UNCTAD many of the concerns of developing countries in the trade field, even as the G-24 extends its own span of interest beyond the BWI to the overlapping

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functions performed, or likely to be performed, by other international organizations. Meanwhile, after a hiatus of more than a decade, UNDP has resumed a modicum of funding support for a project on South-South cooperation assigned to the G-24 Liaison Office in Washington, D.C. Relations with Nongovernmental Organizations

The SWG report had observed that in the major industrial countries a class of NGOs was emerging with an interest in monetary and financial matters, and that “it would be useful to afford them an opportunity to understand the G-24 point of view on various of these issues by entering into a dialogue with them.” The resolution adopted by ministers in October 1994 on “operational mechanisms” was silent on the subject. However, the research program commissioned a study of the role of NGOs, which was discussed at a TG meeting in August 1997.15 The reaction of the TG was not favorable, it being noted that industrial-country “advocacy” NGOs tended to use their influence with their national legislatures and with their representatives in the BWI to impose new “conditionalities” on developing-country governments in areas like human rights and governance, which were far removed from the mandates of the BWIs. For their part, many industrialcountry NGOs felt a reluctance to establish direct contact with developingcountry governments for fear that this might detract from the influence that indigenous civil society organizations should be exercising with their own authorities. For much the same reason, there was general disapproval of attempts by multilateral development banks (MDBs) to create financial dependence relationships with NGOs that might interfere with the autonomy of the NGOs’ operations. The subject remains among the most important to be settled in the future.

Relations with Industrial Countries

From the outset of its existence, interaction with the industrial countries has been at the center of the G-24 and its work. Among the terms of reference of the Intergovernmental Group, the Lima meeting of 1971 provided for evaluating “events in the monetary field, as well as any decisions which might be taken by a single country or a group of countries within the framework of the IMF, relating to the interests of developing countries.” The Manila Declaration of 1997 was more direct in referring to the function of the G-24: it was “to act as a counter to the organization of the developed countries in the Group of Ten and to assist in defining unified or common developing country positions in negotiations between developed and developing countries on matters relating to international finance and development.”16

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A Quarter-Century of Experience

A great deal of thinking on IMS reform issues provided the leitmotif for the written work of the G-24 through the 1980s.17 In the early 1990s, two reports were prepared on the role of the IMF and the World Bank in the debt strategy (1990) and on the implications of the macroeconomic policies of industrialized countries for developing countries (1993).18 The interaction with the industrial countries took a confrontational turn at the meeting of the Interim Committee in October 1994, when the developingcountry representatives rejected a U.S.-British proposal to make a new SDR allocation on the basis of an “equity” criterion and not on the basis of a “long-term global need to supplement existing reserve assets,” as provided for under the current articles of the IMF. An allocation on equity grounds (to accommodate 40-plus members that had joined the IMF after the last allocation in January 1981) would have required an amendment of the articles, and was seen by the developing countries as a rebuff to their endorsement of a proposal by the IMF managing director and as foreclosing any possibility of a “general” allocation.19 In the event, the developing countries accepted an amended proposal for an “equity” allocation at the 1997 annual meeting, but the earlier rejection appeared to have caused some rethinking among the industrial-country representatives about taking for granted the consent of their developing-country “partners” and adopting a more inclusive approach to decisionmaking on international monetary issues.20 A new phase of interaction with the industrialized countries was launched at the TG meeting of March 1997 in Venezuela and was carried forward at the extraordinary ministerial meeting of February 1998, hosted by the same country. What is different about this phase is a marked absence of any confrontational rhetoric and a much greater willingness to concentrate on issues of common concern. Executive directors on the IMF board representing the two countries that had hosted the preceding two G-7 summits (Canada and France) and the host country for the (then) forthcoming summit (United States) were invited to Venezuela to participate in the first day of discussions on topics of their choosing. They chose to discuss the “Globalization of International Capital and Financial Markets” (Karen Lissakers, United States), the “Regulation of the International Financial System” (Thomas Bemes, Canada), and “Good Governance” (Marc-Antoine Athena, France). Their presentations were matched by three from representatives from developing countries (Brazil, India, and Ghana). The ensuing discussion revealed a certain commonality of approach to current issues in the international economic arena, including (1) the need to reflect changing global realities in the evolution of roles for the IMF and the MDBs; (2) the importance of cooperation in strengthening banking supervision and regulation to deal with such problems as money laundering and banking fraud; and (3) the pursuit by all countries of sound macroeconomic policies for the best use of globalized capital markets. Differences of

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opinion emerged on issues of governance; even if a common definition of good governance could be agreed, developing-country participants argued that defining did not resolve problems of jurisdiction and the sharing of responsibilities. At the conclusion of the TG, a working paper was drawn up calling for a proactive dialogue with the G-7 and noting that the process involved in developing that dialogue should emphasize informality of format, technical character of discussion, and pragmatism in the approach to issues. It was agreed by the ministers in April 1997 to authorize the G-24 chairman to forward three issue papers to the G-7 host country on (1) improving coordination and cooperation among relevant authorities for strengthening financial institutions and markets; (2) improving transparency in the award of public-sector contracts; and (3) burden-sharing differences among the G-7 countries (these differences were holding up progress on several issues of great concern to developing countries, especially the poorer countries that urgently needed debt relief as well as assurances of International Development Association [IDA] adequacy). In the event, it was claimed by the G-7 host that the papers arrived too late in their agenda process to be considered. Learning from this experience, the G-24 decided to prepare for the next session of the G-7 summit (scheduled for May 1998 in Birmingham, Great Britain) by adopting a set of issues at its Caracas session in February 1998. The focus was on the implications of the East Asia crisis for the reform of the international monetary system, with special reference to the liberalization of the capital account and the need for stronger cooperation among supervisory and regulatory authorities of developing and developed countries dealing with financial markets and institutions. Issues for the Future

A preliminary question in discussing the future is whether the dichotomy between industrial and developing countries that is central to the existence of groupings such as the G-24 is likely to become obsolete in coming years—if indeed it has not been rendered obsolete already. Those espousing this position argue that as countries that now constitute the South succeed with their own development, their interests begin to converge with those of the more advanced economies in material respects. The decision of countries like Mexico and South Korea to join the OECD (and the desire of some others to follow suit), the willingness of some of the South American countries to become members of the North American Free Trade Agreement (NAFTA) and the adherence to “free trade” arrangements with the European Union by Mediterranean countries, and, generally, the growing integration of the “emerging market” countries into the world capital

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market are offered as evidence of trends that erode the dichotomy. Another angle to the same argument points to important ongoing differences among G-24 members (and among developing countries more generally) and not only between those aspiring to become OECD members and the rest. This fact is remarked on by C. Randall Henning in his 1991 report in terms of the diversity of the membership’s reflecting “the different primary concerns of creditor and debtor, oil and non-oil, poor and middle income, large and small countries.”21 There remain nevertheless fundamental differences in interest and concern between the two groups, that is, industrial and developing countries. The differences are grounded in enormous disparities in income levels and in corresponding power differentials that are unlikely to be erased in, say, the next 25 years, even if these differences are ameliorated in lesser or greater degree by the ongoing integration process. The demographic imperative is another significant divide; many of the advanced economies have aging populations that create intergenerational issues quite distinct from those of most developing countries where the implications of a high, if not rising, proportion of young people in their populations remains the dominant economic issue. The urge of young people in the poorer countries to move to more prosperous ones in search of employment and the restrictions imposed on such migration by the latter countries stands out as the largest lacuna in the globalization of the world economy. Even when developing countries attain higher per capita income levels, their situation as latecomers raises acute questions in areas as disparate as burden sharing in environmental matters or technology transfers or intellectual property rights.22 Finally, differences of political, cultural, and institutional character are bound to persist over long periods despite the progress that could be made over time in the acceptance of more uniform standards of “good” governance, differences that will have to be reconciled since they are unlikely to be erased. If the need to maintain groupings such as the G-24 is granted, there are several questions that must be raised about its future, even if they cannot be answered in any definitive way. The first relates to the size and composition of the G-24 for effective representation of developing-country interests. Another concerns the group’s intergovernmental character and the constraints this implies in a world of powerful markets, transnational corporations, and civil society organs. A third relates to the group’s approach to formulating and advocating common positions in areas that are likely to emerge in, say, the next quarter-century.

Representativeness of the G-24

It was noted earlier that the composition of the group had remained unchanged since its establishment at the beginning of the 1970s. Since that

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time, a number of developing countries have assumed active roles in the globalizing world economy, and their absence detracts from the effectiveness of the group,23 especially when plausible reasons for the countries’ past exclusion no longer apply (e.g., South Africa has ceased to have an apartheid regime). The existing composition suffers from some regional anomalies, such as the absence of important countries in Southeast Asia and East Africa, the former region being especially important as having in it some of the most successful emerging market countries. Even their current travails draw attention, in a backhanded way, to their absence from the G-24. Some of the excluded countries (e.g., Malaysia and Indonesia) have joined with existing G24 members to form a new group—the G-15—and their increasing focus on monetary and financial issues in the wake of the East Asian crisis only serves to underline a deficiency in the representative character of the G-24. There are other intergovernmental groups as well—for instance, the Non-Aligned Movement (NAM), Organization of African Unity (OAU), Organization of American States (OAS), Association of Southeast Asian Nations (ASEAN)—with overlapping memberships and interests with the G-24. However, the comparative advantage of the G-24 lies in its being firmly anchored in the work of the BWI. If these two agencies continue to carry influence and responsibility in coming years, as appears more than likely, their operating modalities and traditions give reasonable assurance that developing-country interests, if trenchantly argued by the G-24, will be taken into account in the group’s deliberations in a more structured and reliable way than could be expected from other institutions, notwithstanding the existence of weighted voting in the BWI. Indeed, seeking more equitable voting arrangements in the BWI could become one of more pressing items for the G-24 agenda of the future.24 The G-24 should not, however, restrict its efforts only to the BWI. The WTO, for instance, is an international organization of growing importance but it has no entity like the G-24 to advocate developing-country positions. It would be valuable for the G-24 to enlarge its involvement in the WTO, as well as support the work of the G-77 in the UN system. In this broader context, an enlargement of membership to take in some of the most active countries in the developing world that are currently excluded would enable the G-24 to speak with a more authoritative voice in all the economic governance bodies in the global arena. But enlarging membership is not a sufficient condition for success. What the G-24 needs to develop is an improved process for position taking within the group itself through intensive discussion among members to identify the priority issues and to decide how to pursue a high-priority agenda with the international and regional financial institutions and with other groupings of developing and industrial countries (see below). This effort will require that the presence of a G-24 focal point, in the shape of the Liaison Office, not only receive the support of the G-9 EDs of

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the BWI, but that the Liaison Office in turn develop a reciprocal capacity to service the G-9 with the help of its research program.

Cultivating Contacts Outside the Governmental Universe

The G-24 is an intergovernmental group and has tended to work within the confines of its universe and to restrict much of its activity to the agenda of the BWI, as well as intergovernmental institutions. Yet one of the greatest challenges of the future is the rapid growth in influence of “transnational society in the form of networks among individuals and non-governmental organizations. . . . [T]he dramatic fall in the cost of long-distance communication will facilitate the development of many more such transnational networks.”25 In the areas of G-24 interest, one can already find such networks operating in industrial countries and enabling their counterparts in developing countries to find their voice by providing them a channel of advocacy and a platform for the dissemination of their views. The G-24 research program has sought to create interest in this area but without evoking much of a resonance from its audience of financial officials, partly out of a sense that “NGOs in industrial countries tend to be single issue advocates.” Also, governance conditions attached to lending transactions by the MDBs under their influence “are seen as imposing the ideological or cultural preferences of advocacy groups on borrowers, thereby inviting the charge that MDBs are being made to serve as instruments of rich country paternalism, especially in their dealings with poorer member countries.”26 While there is an element of truth in these assertions, this does not derogate from the need to adopt a proactive role vis-à-vis the growing community of NGOs to offset through a concerted educational effort the misinformation emanating from unfriendly lobbies, especially in the industrial countries. What is equally, if not more, essential is for developing-country governments to cultivate better communications with civil society organizations operating in their own countries. A special problem exists in relation to the United States and with some other countries that have adopted the U.S. constitutional model of the separation of the three organs of state, as distinct from the Westminster model of parliamentary democracy in which the political party with a majority in the legislature forms the government. Hence a potential for conflict arises when the political party in charge of the executive branch is different from that in control of the legislature. The problem attains its most acute form when this situation prevails (as it often does) in the United States, by virtue of that country’s veto power in the BWI for important decisions that require a qualified majority.27 This raises an issue not dissimilar to that of dealing with NGOs and requires the G-24 to think seriously of developing an educational outreach to legislators in the major industrial countries to make them aware of the realities in the South and how helping to deal with them has important implications for their own welfare.

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Approaches for Dealing with Future Issues

The types of issues likely to emerge in the coming years can be guessed at, though it is certain that some of these guesses will prove wrong and some of the issues that emerge cannot be predicted at all. What is important, however, is not to make predictions but to lay out an approach for dealing with issues as they arise. Too often in the past, the tendency of the G-24 has been to adopt a reactive role and to wait for other actors, either from among the industrial countries or the management of the international institutions, to define the agenda. For the G-24 to grow into a more valuable institution a change to a more activist approach is essential. Taking initiatives will not be without risk, especially when these collide with industrialcountry interests, but without risk there is little hope of progress. It is hardly persuasive to complain that industrial countries do not take the interests of others into consideration. These interests must be articulated and proclaimed through all the channels of dissemination open today in order to build public opinion on issues of G-24 concern and to interact with other actors at all levels—from the highest political to the lowliest organs of civil society, both at home and abroad. A proactive role will require careful intellectual preparation, and it is here that the G-24 research program becomes crucial to the success of the enterprise. This program has provided inputs into the formulation of G-24 positions, especially since the establishment of a TG in 1995 with the specific task of extracting policy implications from the research studies. It is essential to move to a two-track approach: in addition to the longer-range studies designed to identify and analyze emerging issues, the program should be equipped to produce shorter briefs or position papers to help BWI EDs, in the first instance, and their political masters, at subsequent meetings, to obtain external inputs expeditiously on issues featuring in their respective board agendas.28 For this to be accomplished, the research coordinator must work closely with the G-24 Liaison Office and that office with the G-9 EDs of the BWI. Indeed, for the proposal to be efficiently implemented, a decision to locate the direction of the research program at the center of the G-24 administrative and support system, that is, at or near the G-24 Liaison Office, deserves consideration. Notes

1. The managing director of the IMF and the secretary general of UNCTAD were in attendance at both meetings. In another coincidence, the representative of Sri Lanka at these meetings was Lal Jayawardena, at the level of the deputies. 2. Quoted in “A Brief History of the Group of Twenty-Four” by Eduardo A. Zalduendo, reproduced in “Documents of the G-24 (1972–1986),” mimeo (1986). 3. Caracas Declaration II (issued 9 February 1998). 4. Ibid.

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5. The first was a foreword by Juan V. Sourrouille, minister of economy of Argentina and chairman of the G-24 in 1986, to the volume “Documents of the G24 (1972–1986)”; the second was a study commissioned by the G-24 Research Program titled “Two Decades of Monetary and Financial Cooperation Among Developing Countries” authored by C. Randall Henning (International Monetary and Financial Issues for the 1990s, vol. 1, United Nations, 1992). 6. The G-24 sponsored a conference at Cartagena de Indias, Colombia, on 18–20 April 1994; the papers and proceedings of the conference were published under the title The International Monetary and Financial System: Developing Country Perspectives, edited by G. K. Helleiner, the G-24 research coordinator (London: Macmillan, 1996; and New York: St. Martin’s Press, 1996). 7. In-house reviews are documented in a report on the “Funding of G-24 Activities” (September 1995); a report on the “Future Role of the Group of TwentyFour” submitted by the Pakistan Delegation (April 1996); a “Status Report” on the same subject submitted by that delegation (September 1996); likewise, a “Second Status Report” (April 1997). Thereafter there are no separate documents, with discussions on the subject being held in restricted sessions of the ministers during their two meetings in 1997 and culminating in the extraordinary ministerial meeting in February 1998. (G-24 documents are in an unpublished mimeo.) 8. The G-24 research program has been operational since 1975, under the direction of Sidney Dell of the UN Secretariat until 1990, and thereafter under Professor G. K. Helleiner of the University of Toronto. In the early years the program was funded by UNDP. From 1987 onward it was supported by three industrial countries, Canada, Denmark, and the Netherlands, which contributed to a trust fund administered by UNCTAD. Starting in 1995/96 members of the G-24, and two observer countries—China and Indonesia—have also made contributions to the trust fund, averaging $100,000 per year, or the rough equivalent of that provided by the industrial-country donors. 9. Examples of position papers are one on “Issues Relating to the Treatment of Capital Movements,” prepared in August 1997 for the IMF G-9, and another on “Net Income Dynamics” of the World Bank, prepared in April 1998. 10. While all G-24 members are represented in one or other of the nine constituencies on the BWI executive boards, two nonmembers—China and Saudi Arabia—which have their own executive directors, often join in the deliberations of the G-9, making up a G-11. 11. This was particularly apt to be true for the bigger developing countries, like Argentina, Brazil, China, India, and Saudi Arabia, whose nationals are members of the Executive Board. 12. At the second ministerial meeting of the G-77 held in Lima, Peru, in October/November 1971, the government of Peru was authorized to consult with other ministers on the formation of an Intergovernmental Group whose functions would cover, inter alia, keeping “under review the course of the international monetary situation.” At a meeting of the G-77 in 1976, the terms of reference of the Intergovernmental Group were enlarged within the framework of the Manila Declaration and were subsequently endorsed by the G-24 ministers in 1977. 13. The ten common members are Algeria, Argentina, Brazil, Egypt, India, Mexico, Nigeria, Peru, Sri Lanka, and Venezuela. They were joined by Chile, Indonesia, Jamaica, Kenya, Malaysia, Senegal, and Zimbabwe. The G-15 actually includes 17 members, all of them developing countries. There is another “G-15” that is made up of the members of G-10 plus some developing countries; this group was set up in 1998 but has not been formalized.

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14. Statement by Mainnohan Singh, finance minister of India, at the inaugural meeting of the South Center Council of Representatives (18–19 September 1995). 15. Paper by Nancy Alexander (Bread for the World Institute, USA) and Charles Abruge (African Secretariat, Third World Network) titled “NGOs and the International Monetary and Financial System” (July 1997). 16. Both quotations are taken from the Report of the Special Working Group (Antigua, Guatemala, August 1994) (unpublished mimeo). 17. Four reports were issued in the period: “Program of Action on International Monetary Reform” (Belgrade, 1979); “Revised Program of Action Towards Reform of the International Monetary and Financial System” (Washington, D.C., 1984); “The Functioning and Improvement of the International Monetary System” (Washington, D.C., 1985); and “The Role of the Fund in Adjustment with Growth” (Washington, D.C., 1987). 18. A report on the subject was commissioned by the G-24 in March 1993 and prepared by the present author for discussion at the September 1993 meeting of ministers (unpublished mimeo, 1993). Its main conclusions are included as an annex to a paper titled “Implications for IMF Policies Arising from Effects on Developing Countries of Industrial Country Macroeconomic Policies” included in G. K. Helleiner, ed., The International Monetary and Financial System: Developing Country Perspectives (New York: Macmillan, 1996). 19. The managing director had proposed a 36 billion SDR allocation in two parts: (1) 20 billion SDRs under the current articles to be distributed strictly in proportion to current quotas, and (2) 16 billion SDRs to correct the inequity in the SDR system resulting from the fact that members who had joined the fund since January 1981 had not received any allocations. The G-7 wanted a much smaller allocation (not to exceed 16 billion SDRs) and that could only take place after an amendment of the articles, and would therefore clearly indicate that the allocation was not meant to meet a “long-term global need,” but essentially to correct the inequity in the SDR system. 20. The agreement reached in Hong Kong was regarded as superior to the Madrid offer for three reasons: the amount, equal to the outstanding SDR allocations, was larger; it resulted in a consensus on a common conception of what the SDR role should be in the future; and it was an agreement among all the members, not the view of a group of countries being imposed on the rest of the membership. 21. Henning, “Two Decades of Monetary and Financial Cooperation,” endnote 5. 22. See, as an example, Richard N. Cooper’s article “Toward a Real Global Warming Treaty” (March/April 1998) on the problems associated with setting targets on greenhouse gas emissions. If they are set roughly in proportion to recent emissions of pollutants, “they allocate property rights to the existing tenants, conferring ownership on recent users. Targets allocated on this basis would be completely unacceptable, however, to countries that are or expect to be industrializing rapidly. They will argue that most of the existing greenhouse gases generated by humans were emitted by today’s rich countries and that these countries should therefore bear more responsibility for cutting back. At the other extreme, simple redistributive justice would require that emission targets be based on population. This would favor heavily populated poor countries, such as China, India, Indonesia, Bangladesh and Nigeria. . . . Application of this principle would require drastic cutbacks in emissions by today’s rich countries, implying radical changes in living conditions there. . . . Reductions in living standards could be mitigated, but not avoided, by the sale of unused emission rights by poor countries to rich ones. But the financial transfers involved would be far more than is likely to be politically tolerable.”

42

A Quarter-Century of Experience

23. It has been argued that because all G-77 members are permitted to attend as observers, membership in the group is not essential. However, in the past only China, Morocco, and Saudi Arabia have made it a practice to regularly send observers to G-24 meetings. 24. See, for example, a G-24 research study by Ngaire Woods, “Governance in International Organizations: The Case for Reform in the Bretton Woods Institutions,” in International Monetary and Financial Issues for the 1990s, vol. 60 (United Nations, 1998). 25. Robert E. Keohane, “International Institutions: Can Interdependence Work?” Foreign Policy (Spring 1998): 82–96. The growth of networks has “been aided greatly by the fax machine and the Internet and by institutional arrangements that incorporate these networks into decision-making.” 26. Aziz Ali Mohammed, “Notes on MDB Conditionality on Governance” (International Monetary and Financial Issues for the 1990s, vol. 8 (United Nations, 1997). 27. The U.S. voting power in the IMF is 17.78 percent, whereas important decisions require a qualified majority of 85 percent of total voting power. 28. The idea has been tried on three or four occasions on an experimental basis since the setting up of the G-24 Liaison Office.

PART 2 Two Crucial Problems: Income from Oil Exports in the 1970s and the Asian Crisis in the 1990s

3 Oil Export Revenues and Their Circulation in the International Financial System Abdelkader Sid Ahmed

The Oil Boom and the “Petrodollar” Emergence

Except for the specific case of the Gulf emirates, which already had a structural surplus, the “petrodollar” phenomenon was historically the byproduct of the 1973–1974 and 1979–1980 price adjustments. These two major changes in crude oil price occurred after a long stable period in the oil market. Oil prices went from $1.20 per barrel at the beginning of the century to $1.60 at the end of the 1960s. The Tehran Agreement in September 1970 opened the door to price changes, the first round of which took place in October 1973, with prices remaining relatively stable until 1979. A second round of price increases was marked by the Iranian Revolution and translated into a price doubling in December 1979. Price increases in 1973–1974 and 1979–1980 translated into a spectacular oil revenue growth that altered world earnings distribution. From $15.2 billion in 1972, oil revenues went to $110 billion in 19741 and then to $282.6 billion in 1980. That is about 12 times their 1972 level. The Gulf economies already had (as did Libya to a lesser degree) a high per capita income before the crude oil price adjustment and therefore profited from an exceptionally high savings rate.2 These oil revenue growths could only increase this rate. Sparsely populated and with a very limited resource base, these economies’ domestic absorption capacity was among the weakest. Revenues of the countries in the first category, less populated and with weak absorption capacity (Kuwait, United Arab Emirates, Qatar, and Libya), were multiplied by over 20 between 1972 and 1980. If a second category is added (Saudi Arabia and Gabon) accumulated revenues of Categories I and II increased over 24 times. In parallel, the weight of those economies with structural surplus within the Organization of Petroleum Exporting Countries (OPEC) went from 49.6 percent to 66.6 percent, or from half to two-thirds (see Table 3.1). 45

46

Two Crucial Problems

Table 3.1 Oil Revenues: OPEC Countries with a Surplus, 1972–1981 (in billions of dollars) Country

1972

Category I United Arab Emirates 0.55 Kuwait 1.65 Qatar 0.25 Libya 1.59 Total 4.04 Category II Saudi Arabia 3.10 Gabon — General total (I+II) 7.14 Category III Total OPEC 14.37 Category IV Total OPEC countries with a surplus (I+II/III in %) 49.6

1975

6.80 8.59 1.75 6.76 23.90

29.47 0.50 53.87

106.92 50.4

1979

12.86 17.29 3.69 15.94 49.78

62.85 0.90 113.53

200.08 56.7

1980

19.39 18.93 5.37 21.90 65.59

108.17 1.60 175.36

282.62 62.0

1981

18.76 14.22 5.49 14.93 53.40

118.99 1.70 174.09

261.07 66.6

Source: A. Sid Ahmed, 1983, OPEC, Statistical Bulletins OPEC, 1995–1996 and other years.

Trade balance analysis of the economies concerned confirms this fact. Imbalances observed at balance level originate from what has been named the “oil surplus.” In fact, the oil surplus represents an addition for the same amount to world savings in the form of foreign capital assets. Contribution to the world economy was substantial since world oil trade went from $28 billion in 1970 to $535 billion in 1980. That is 21 percent of world trade in 1980 against 7 percent in 1970. Consequently, oil revenues of OPEC went from over $14 billion in 1970 to $106 in 1975, and reached their highest point, $282 billion, in 1980. At the same time, current surplus of countries with surplus went from $1.8 billion in 1970 to $67 billion in 1975, and reached a peak of $97 billion in 1980, after a drop to $13 billion in 1978 (see Table 3.2). The inclusion of other non-OPEC-member oil economies would not modify this scenario since, outside of Brunei, these are populated economies with strong absorption capacity (e.g., Mexico, Egypt, Angola, Syria, Oman, and Malaysia) or with relatively little production (e.g., Bahrain, Tunisia, or Trinidad and Tobago). OPEC’s current surplus at the highest surplus peak in 1980, of close to $103 billion, appeared like in 1979 some billion dollars above that of the total of countries with surplus. This was due to a never before equaled windfall surplus in countries like Algeria, Indonesia, and Nigeria. Two other non-OPEC economies had surplus production that same year: Oman and Trinidad. The great importance of this amount becomes evident when compared to $114 billion in total exports from Great Britain and $111 billion from France in 1980. The “surplus” concept has had many controversial definitions. 3 Surplus as defined here represents OPEC countries’ surplus balance of current

Oil Export Revenues and Their Circulation

47

Table 3.2 Oil Economies’ Balance of Payments, Current-Account Balance, 1970–1981 (in millions of dollars in 1970, and in billions of dollars from 1975 through 1981) Country

United Arab Emirates Venezuela Kuwait Qatar Libya Saudi Arabia Gabon Iraq Iran Total of countries with surplus Total OPEC

1970

90 — 853 — 758 71 –3 104 —

1,876 —

1975

3.36 2.17 5.93 1.19 0.39 14.38 — 2.70 4.70

67.46 32.11

1978

1.69 –5.73 6.13 0.92 0.73 –2.21 — 4.08 0.10

13.65 –2.98

1979

5.25 0.35 14.03 1.28 3.77 10.20 — 11.11 11.96

57.94 59.00

1980

10.60 4.72 15.30 2.64 8.21 41.50 — 14.50 –2.43

97.47 102.96

Source: A. Sid Ahmed, 1983, OPEC, Annual Statistics Bulletin, 1995.

1981

9.20 4.00 13.69 2.38 –3.96 39.62 — –10.60 –3.44

68.09 43.95

payments: that is, their international trade balance increased by foreign investment revenues and diminished by immigrant workers’ remittances. Important transfers made by several of these countries in favor of expatriates—especially by developing countries—are not taken into account in this definition. From 1981 through 1996, favorable crude oil terms of trade deteriorated due to an inversion in fuel market trends that had a very negative effect on both oil revenue levels and surpluses (see Table 3.3). The latter eroded even more due to the price paid by Gulf countries for Kuwait’s liberation in 1991–1992. After a $32.50/bbl. peak in 1981, nominal crude oil price declined, dropping to $13.53/bbl. in 1986. A combined effect of inflation and exchange rates (notably dollar depreciation) that started in 1991 had set crude oil real price at around $5 per barrel—only twice its 1972 level on the eve of the first price adjustment (see Table 3.4). With the exception of 1985, 1989, 1990, and 1997, OPEC’s current balances appeared negative. Saudi Arabia saw its current balance worsen dramatically. In 1991 the peak of –$27.54 billion (not shown in Table 3.3) was reached. Only the United Arab Emirates and Kuwait (1991 and 1992 excluded) showed financial structural surplus throughout the period. Oil Revenues Recycling in the International Financial Market

From 1973 through 1996, OPEC’s accumulated oil revenues rose to $3,314.2 billion. Estimates at the end of December 1997 were $171 billion, increasing

48

Two Crucial Problems

Table 3.3 Oil Economies’ Balance of Payments, Current Balance, 1982–1996 (in billions of dollars) Country

United Arab Emirates Venezuela Kuwait Qatar Libya Saudi Arabia Iraq Iran Total countries with surpluses Total OPEC

1982

1984 1986 1988

7.0 7.46 2.37 –4.24 4.65 –2.24 — — — 1.12 0.83 –0.01 –1.50 –1.40 –0.16 7.57 –16.85 –11.79 –11.90 –1.70 –3.04 5.33 –0.41 –5.15

1990 1992 1993 1995

1996

2.53 5.23 3.04 0.18 1.22 6.39 –5.80 8.20 –3.74 –1.99 2.25 7.34 — — — — — — –0.26 0.30 –0.90 –0.06 –1.80 –2.50 –1.80 2.20 1.40 –1.30 1.90 1.00 –7.34 –4.15 –17.74 –17.26 –5.32 0.20 –0.14 0.50 –1.50 –0.25 –0.40 –0.32 –1.80 0.32 –6.50 –4.20 3.23 4.96

21.42 12.94 2.37 2.53 16.75 4.44 0.18 8.60 19.89 –4.09 –4.28 –20.53 –13.84 19.99 –24.99 –25.72 –7.33 17.35

Source: UNCTAD, International Commerce and Development Statistics Manual, Geneva, Feb. 1993.

1973–1997 accumulated revenues to $3,485.2 billion. Accumulated current surplus rose in the period 1973–1996 to $652.4 billion. What has happened to those considerable amounts? This section deals with that issue. First, let us specify that financial surplus can be defined as “USA dollars realized through crude oil sales, the product of which has not been absorbed by internal development needs.”4 If within the frame of the subsoil “wealth” transformation process into capital assets generating revenue, the surplus production is sold and transformed into monetary units, a petro dollar surplus will emerge. The purchasing power of this U.S. dollar-denominated surplus will then depend on the North American inflation rate5 and also on the rate at which the dollar is exchanged in international monetary markets. This situation had mostly economic implications, but also political ones, some of which are discussed below. In a certain way, petrodollar concentration in the United States holds this capital surplus hostage, as shown by Iranian property frozen there. Oilexporting countries do not have a surplus unless their absorption capacity is inferior to crude oil sales. We have seen that the number of OPEC economies that fit this criterion is quite reduced today. Saudi Arabia was the greatest surplus holder at the end of the 1970s, but has since been structurally in deficit. Finally, surplus does not represent “real wealth” such as highly qualified labor, highly productive equipment, or infrastructure. In fact, these OPEC economies still face the crucial problem of identifying at a given time horizon the crude oil price package that maximizes their product’s revenue. In short, this means solving the optimization problem in the long term and identifying the optimal rate at which to convert nonrenewable natural resources into financial capital and real capital alternatives.6 It should be recalled here that liquid (currency) or financial (stock) capitals gradually erode with inflation and exchange rate movements, and especially

Oil Export Revenues and Their Circulation

49

give way to financial and monetary crises like those that recently hit emergent Asian markets. Therefore, the development of oil-exporting economies (OEs) lies on the conversion of their subsoil resources into industrial, educational, and technological assets and other productive capital forms. An optimal extraction rate would be one that maximizes the present value, discounting any revenue created through the conversion process. Petrodollars accumulated by some countries reflect production policies disconnected from optimal production rates. In fact, the differences between volumes produced and the so-called optimal production volumes constitute a “subsidy” granted to big importing nations in “real terms”7 (see Table 3.4). Oil surplus, as mentioned above, was an addition in the same amount to world savings in the form of foreign capital assets. Which were the effects of the redistribution of such considerable world earnings (oil revenues) and of the petrodollar emergence? OPEC savings growth could have emerged in three scenarios: a parallel increase in world real investment rates; a nominal diminishment in savings somewhere else in the world to compensate for OPEC savings growth (no variation in savings and investment in the world); neither of the former scenarios but an increase in the volume of financial assets translated into an increase in nominal investment.8 In practice, it was the third scenario and not the first two (reinvestment and redistribution scenarios) that prevailed: the placement scenario. Essentially, in this scenario the relationship between real investment and financial asset flow is broken: capital assets increase independently from real investment and OPEC savings adjustments are essentially financial. This scenario implies that global allocation of resources between investment and consumption is really not affected by oil price increases. There was no apparent dissaving anywhere in the world. Faced on one side with a growing oil bill and a commercial deficit surge, and on the other with parties reluctant to transfer wealth to OPEC and to reduce their consumption levels, countries in deficit issued new capital assets that OPEC countries rushed to acquire.9 In this scenario, OPEC countries increased their savings and held a preferred way of wealth, whereas importing countries minimized real transfer of resources (consumption and investment and/or property wealth from consumer countries to OPEC). OPEC savings thus increased without a corresponding real investment growth or a compensatory dissaving. Growth of capital assets held by OPEC countries with a surplus implied, therefore, a corresponding financial engagement growth for countries in deficit. This scenario suits best the ensuing adjustment process after 1974. Data on investment rates, inflation, capital asset flows, and OPEC surplus go in this direction. Real investment rates experienced no improvement after this adjustment, in fact, very much the opposite. The wealth transfer scenario where fears that newly enriched oil countries would acquire the

50

Two Crucial Problems

Table 3.4 Oil Prices Evolution in Real and Nominal Terms, 1970–1997 (dollars per base barrel 1973 = 100)

1970 1971 1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

Nominal Oil Pricea 1.67 2.04 2.30 3.07 10.77 10.73 11.51 12.40 12.70 17.28 28.67 32.50 32.38 29.04 28.20 27.01 13.53 17.73 14.24 17.31 22.26 18.62 18.44 16.33 15.53 16.86 20.29 18.88e

Nominal Price Adjusted for:

Exchange Ratesb 1.99 2.38 2.48 3.07 11.20 10.95 12.66 13.40 12.40 16.35 27.06 35.17 39.39 37.95 40.43 40.11 16.24 18.92 14.77 18.94 22.36 18.90 18.25 17.85 16.83 17.58 21.24 —

Inflation Ratesc 1.98 2.30 2.47 3.07 9.49 8.52 8.47 8.43 8.07 10.02 14.77 15.19 14.11 12.06 11.16 10.24 5.02 6.38 4.96 5.75 7.03 5.63 5.40 4.65 4.32 4.56 5.36 —

Combined Ratesd 2.36 2.67 2.68 3.07 9.87 8.70 9.31 9.10 7.88 9.48 13.94 16.43 17.16 15.76 16.00 15.21 6.02 6.81 5.14 6.30 7.06 5.71 5.34 5.08 4.68 4.76 5.61 —

Source: OPEC, Annual Statistical Bulletin (1996): 122. Notes: a. From 1970 to 1981, the Arab light crude official price; as of 1982, the OPEC spot reference basket price. b. Based on weighted average index of currency exchange rates of the countries set forth in the Geneva I Agreement and the United States vis-à-vis the U.S. dollar (weights: OPEC imports from Geneva I countries and United States). c. Based on weighted average consumer price indices of Geneva I countries and United States (weights: private consumption of Geneva I countries and United States). d. Based on combined indices of exchange rates and inflation. e. November 1997.

West’s and Japan’s productive jewels did not happen either.10 Essentially the bulk of petrodollars was kept for security, relative liquidity, and anonymity reasons—placed, for instance, as bank deposits and short-term petrodollar loans. The annual average growth rate of developed countries with a market economy declined considerably: over 5.1 percent in 1960–1970, 3.1 percent in 1970–1980, and 2.9 percent in 1980–1991. The same happened to gross internal investment. Annual average growth was 3.4 percent for 1965–1980 and 3.1 percent for 1980–1987. The 1965–1980 breakdown confirms this strong

Oil Export Revenues and Their Circulation

51

deceleration from 1974: around 4.8 percent in 1966–1970 and 2.0 percent for 1970–1978, with the 1970–1973 period showing a better performance than 1973.11 Mediocre performance continued beyond the repercussion of the second crude oil price adjustment in 1979–1980, with 2.7 percent for 1980–1985. In the same period, in 1982 a drastic drop in trade, in crude oil terms, began. In parallel to these declines in global growth and developed countries’ investment, capital asset flows increased substantially. Concern about international capital asset growth originates in several indicators. The rapid Eurocurrency market expansion and countries’ outstanding indebtedness provide a good picture of the fate of petrodollars following crude oil price adjustments. First of all, the Eurocurrency market went through a rapid and regular expansion after the mid-1960s, and this expansion was accelerated after crude oil price adjustments. Market volume went from $12 billion in 1964 to $177 billion in 1974, then to $575 billion in 1980, and to $686 billion in 1982. 12 At the same time, the proportion of loans from this market to developing countries rapidly increased, reaching approximately 50 percent of the total amount of loans at the end of the 1970s. These extraordinary flows quickly led to “privatizing” developing countries’ debt structure.13 From almost $50 billion in 1970, developing countries’ external public debt went to over $628 billion in 1982. It can be said that this considerable increase concerned three developing country categories: oil-exporting countries ($176 billion against $10 billion), manufactured goods exporters ($193 billion against $17 billion), and strongly indebted countries ($304 billion against $17 billion). The evolution and behavior of interest rates deserve an explanation here. Parallel to the growth and increase in capital asset flows, interest rates climbed substantially.14 The United States, first beneficiary of OPEC funds during the spring of 1974, signaled interest rate increases: discount 8.0 percent, federal funds 13.5 percent, deposits 12.5 percent, and banking base 13.0 percent. Later, percent rates of 18 to 21 percent became common in the United States and elsewhere.15 This phenomenon was aggravated by the fact that “privatization of debt” unleashed on average shorter maturity terms and on the increased proportion of credits subjected to variable commercial interests. 16 This, in turn, transferred cyclical and long-term rate variations to debtors. In developing countries an already mounting inflation before 1973—more specifically in foodstuff prices—almost doubled between 1971 and 1974 (13.5 percent against 6.8 percent). Two-digit inflation became standard, with three-digit inflation in some Latin American countries (notably Argentina and Chile). In 1981–1982 surplus erosion started the return to one-digit inflation in developed countries (7.9 percent in 1981–1982 against 10.5 percent as late as 1980–1981). This inflation strongly affected OPEC savings. Financial surpluses went from $58.4 billion in 1974 to $13.4 billion in 1978 (Appendix 3.1).

52

Two Crucial Problems

However, this decline cannot be attributed only to the rise in imports’ real terms; it was also a result of the drop in oil prices’ real terms throughout the period considered. These prices declined in real terms by 25 percent in constant dollars between 1974 and 1978, 40 percent in German marks, and 30 percent in yen.17 In an influential article published in 1978, on the eve of the second oil price adjustment, Walter Levy perfectly explained how this OPEC savings problem was fixed. The post-1974 upheaval in the economic and financial structures of Western industrialized countries and in those of the world in general, has been contained within controllable limits on one side through the economic slowdown and the imagination of Western public and private financial institutions—but certainly on the other side as well, because the main OPEC countries did not want or were not in the position to reduce production and push to the maximum their indisputable negotiating power. OPEC advances in price matters remained this side of the global inflation rate and of the dollar depreciation since the fourfold price increase in 1974. Meanwhile, real oil prices fell substantially. Simultaneously, the bulk . . . of petro-dollars . . . was strongly eroded, frequently due to prestige outlays by countries close to the West. This deadened the shock for industrialized economies. The petro-dollar flow was channeled into the financial system, considerably increased and a major durable problem source. It did not turn out to be the nightmare many feared in 1974.18

It is understandable from then on why the second shock of 1979– 1980, with the experience of the first one, managed to be even more easily “collected” by the industrialized economies, even though the implied surplus reached amounts not comparable to those of 1974.19 It is plausible, therefore, to conclude that the world, faced with oil savings growth, mostly chose the placement scenario mentioned above. The bulk of petrodollars was, from 1974 through 1982, the subject of placements in the United States (in treasury bonds and other short-term placement instruments) or of deposits in Western European banks (see Table 3.5). Petrodollars served as well to increase oil-exporting countries’ official reserves. These (less gold) multiplied by a factor of 6.7 between 1973 and 1980, while IMF member countries’ reserves only multiplied by a factor of 2.8.20 Petrodollars were also recycled by industrialized countries’ commercial banks and by international institutions: in return for petrodollar deposits or certificates of deposit banks could increase their lending capacity. From the beginning of the 1970s both savings and global investment diminished in GNP percentage at world level. Meanwhile, OECD countries had become net capital importers since 1974, with a one-point difference between investment and savings coefficients at the end of the 1980s. In the 1970s, OPEC countries assumed financing (as long as there were petrodollars)

Oil Export Revenues and Their Circulation

53

Table 3.5 Petrodollar Allocation, 1974 to the First Half of 1982

Year

Cash Investible Surplus (in billions of dollars)

1974 61.50 1975 40.25 1976 39.25 1977 43.75 1978 19.00 1979 65.00 1980 123.25 1981 69.25 1982 (first half) 4.50 Cumulative 1974–1982 (first half) 465.75

Percentage of Total Investible Surplus

United States 19 20 28 17 2 11 11 24 n.a. 19

Eurobanking Market

All Developed Countries and Nonmarket IFIsa

22

71

37 20 28 27 13 45 26 4 17

84 75 80 69 45 71 65 64 83

Source: U.S. Department of the Treasury data. Note: a. IFIs = International financial institutions, special drawing rights, and gold.

of the bulk of the OECD21 investment-savings gap. In the 1980s, newly industrialized Asian countries and Japan took over.22 For the banks, their important potential clients were many developing countries worried about pursuing their development objectives and about financing their oil bills. The petrodollar recycling process enabled commercial banks, international lending institutions, and banking consortia (especially Arab ones) to provide financial assistance to developing countries.23 Industrialized economies purchased OPEC oil, and developing countries paid for their oil and other foreign goods and services with money borrowed from Western commercial banks. The recycling process locks when commercial banks and institutions obtain liquid assets and investments from oil-exporting economies. This was the case at the time of both shocks. 24 Table 3.6 shows all recycling process operations per the actor. Appendix 3.2 gives better evidence of the crucial role played by the United States in this mechanism. Oil Exporter Aid to Other Developing Countries

Petrodollar accumulation enabled oil economies to join the group of the world’s great aid donors. This aid was historically distributed through four channels: multilateral arrangements, official aid for development, bilateral arrangements, and diverse OPEC countries’ funds or institutional aid agencies. 25 OPEC and OPEC member country institutions’ total accumulated engagements amounted at the end of 1996 to $65 billion. Accumulated

61.50

72.25 –11.25 0.50

57.75

6.50 6.00 3.75

5.10 0.20 0.90 0.20 4.20 0.70 22.50 7.50

11.50

40.25

36.75 –0.25 3.75

37.60

9.75 7.25 4.25

0.50 2.00 1.60 1.70 0.60 1.70 8.00 0.25

8.10

1975

39.25

39.00 –7.50 7.75

39.20

9.25 7.50 1.25

–1.00 4.30 1.20 1.80 1.90 3.00 11.00 –1.00

11.20

1976

43.50

31.50 2.25 9.75

38.30

9.25 8.50 0.50

–0.90 4.30 1.70 1.40 0.40 0.40 12.00 0.75

7.30

1977

19.00

–1.00 1.25 18.75

15.90

5.75 6.50 0.50

–0.90 –1.50 0.80 0.80 0.80 0.40 2.50 0.25

0.40

1978

65.00

63.00 –6.25 8.25

53.45

8.25 8.50 –0.50

3.30 –1.20 0.40 0.70 5.10 –1.30 29.00 2.50

7.00

1979

123.25

118.00 1.00 4.25

90.10

25.75 10.25 4.50

1.40 8.20 3.50 1.20 –1.20 1.00 32.00 3.50

14.10

1980

69.25

61.00 4.25 4.00

57.10

20.00 12.75 4.00

–0.50 10.90 3.50 1.20 –1.90 3.40 2.75 1.00

16.60

1981

4.50

–2.25 4.50 2.25

9.50

5.00 5.75 0.50

–0.70 5.30 0.20 0.50 6.80 0.80 –15.00 0.75

12.50

465.75

418.25 –11.75 59.25

399.20

99.50 73.00 17.75

6.50 32.50 13.40 9.50 16.70 10.10 104.75 15.50

88.70

1st Half Total 1974 1982 to 1982

Source: U.S. Department of the Treasury, Office of International Banking and Portfolio Investment, International Capital Reports, February 18, 1983. Notes: a. Figures have been rounded; b. Direct investment, prepayment for U.S. exports, placements in nonbanks; c. Excludes foreign currency deposits that are included in Eurobanking market; d. Includes grants; e. IFIs = international financial institutions; SDRs = special drawing rights; f. Cash surplus less allocated surplus.

Investible cash surplus discrepancyf

Current account surplus Lag in receipt of oil revenues Net borrowings

Total allocated

United States Treasury securities: Bills and certificates Bonds and notes Other marketable U.S. bonds U.S. stocks Commercial bank liabilities Otherb Eurobanking market United Kingdomc Other developed/ nonmarket countries Less developed countriesd IFIs, SDRs, golde

1974

Table 3.6 Estimated Distribution of OPEC Investible Surplus, 1974 to the First Half of 1982a (in billions of dollars)

Oil Export Revenues and Their Circulation

55

disbursements amounted to $46 billion (see Table 3.7 on p. 57). Contributions from “trust funds,” windows opened at regional banks for development by Venezuela, Nigeria, and Algeria, should be added here. At the end of 1996 these contributions to projects were distributed as follows: energy (22.9 percent), transportation and telecommunications (23.4 percent), national banks for development (1.8 percent), agriculture and farm produce (19.2 percent), industry (12.8 percent), education and health (5.2 percent), water (10 percent), and miscellaneous (4.7 percent). Assistance then granted concerned 52 African countries, 6 European countries, 44 Asian countries, and 31 Latin American and Caribbean countries. The OPEC fund for international development deserves particular attention in this respect. The objectives assigned to the fund at the beginning were two:26 to sustain developing and non-OPEC countries’ efforts for development by reinforcing solidarity links between them and OPEC countries, and to help establish a more equitable world economic order. The Algerian-Venezuelan development bank project adopted at the December 1979 OPEC conference in Caracas—the first stage of which was to perpetuate OPEC’s fund—went even further with its two windows: to aid the balance of payments and to assist development aiming at reinforcing collective autonomy in the South.27 In fact OPEC’s fund differed notably from the World Bank practices, which had been largely adopted by other international financial agencies. The OPEC Fund was the first institution to combine support to the balance of payments with aid to projects. The fund’s direct assistance to states also incorporated financing from other development agencies whose participation was important for developing countries. Through its assistance to the balance of payments, the OPEC Fund was in a position to have states release counterparts in local currency to face local costs of projects and development programs. In this way, the bottleneck resulting from the assistance of many existing agencies to finance only projects’ costs in foreign currency was overcome.28 The OPEC Fund was, moreover, the first institution to avoid duplicating bureaucracy in established agencies and to benefit from the opportunities offered by those agencies in favor of beneficiary countries. The IMF showed the agencies that the financing process could be carried out faster, and was able to start a dialogue on lending procedures simplification with them. At the same time, beyond its financing institution for development role, the fund became the closest linking instrument between OPEC and other developing countries. For example, it supported the implementation of the International Fund for Agricultural Development, and participated in the negotiations to create the common fund for basic products and in its financing. In more general terms, the OPEC Fund developed cooperation with other agencies in three areas: support to new institutions and to the development of new aid policies that contribute to changes in international economic

56

Two Crucial Problems

relationships; establishment of dynamic working relationships with big financing institutions for development, specifically with those of OPEC member countries; and project and program cofinancing with other development financing sources, and also with competition-oriented institutions. Additionally, OPEC countries played an important role in reinforcing South-South cooperation. Several conferences were held on the subject of economic and technical cooperation, notably those in Buenos Aires (1979), Caracas (1980), New Delhi (1981), and again Caracas (1989), on occasion of the G-77 25th anniversary. Paragraph 5 of the declaration of the last conference reads, “South-South cooperation is necessary to reduce developing countries’ vulnerability to external factors and to maximize complementarities in order to accelerate the development of their economies.”29 Earlier, the Caracas Action Program, adopted in 1980, confirmed that “economic cooperation between developing countries offers the opportunity to take advantage from existing and directly potential complementarities.”30 In fact, resource transfers among developing countries in favor of investment were substantial. Also, a certain amount of bilateral and multilateral institutions were established, especially between Arab countries and OPEC sources and other developing countries—for example, the Gulf’s national investment companies; the Islamic Bank for Development, favoring equity investments, with a total disbursement of approximately $13 billion at the end of 1996; and the Kuwaiti Fund that, in addition to lending, launched investment operations (its disbursements at the end of 1996 were almost $7 billion). In 1981 Arab Gulf countries created the Program for UN Development Agencies (the AG Fund). And, created in 1973, the Arab Bank for Economic Development in Africa (BADEA), which had total disbursements of almost $1 billion by the end of 1996. Finally, there was the Venezuelan Investment Fund, created in 1974, whose interventions focused on the region’s countries and whose total disbursements amounted to almost $2 billion by the end of 1996 (Table 3.7). Resource transfers less Western banks’ and institutions’ recycled surplus rose to $65 billion at the end of 1996 (total liabilities) and accumulated disbursements to over $47 billion. Ten percent of the total amount of OPEC countries’ current surplus had been transferred to other developing countries by the end of 1976 (Appendix 3.1 and Table 3.7). Loans on OPEC accounts should be added to these transfers, as well as the transfers of gold sale profits made by several OPEC countries to the IMF Trust Fund in 1981.31 It is worth noting that several institutions pursued their actions, notwithstanding the collapse of the current surplus since 1982–1983, thanks to capital already liberated in the 1970s by most of them and by regular institutions. During the 1974–1982 period of splendor (see Figure 3.1 on p. 58), petrodollars allocated (donations included) to developing countries amounted

Oil Export Revenues and Their Circulation

57

Table 3.7 Aid from OPEC: OPEC Countries’ Multilateral and Bilateral Institutions and “Trust Funds”—Through 1996 (in millions of dollars) Institutions

Total OPEC

AAIDa (November 1976) AG FUNDb (1981) AMFc (1976) Arab Fund (December 1971) AFTPd (1989) BADEAe (November 1973) Is BD (October 1975) OPEC Fund (January 1976) Abu Dhabi (July 1971) Iran Organization (1975) Iraqi Fund (June 1994) Kuwaiti Fund (December 1961) Saudi Fund (September 1974) Venezuelan Investment Fund (June 1974)

Trust Funds with Regional Banks for Development Nigerian Trust Fund (1976) Venezuelan Trust Fund (1975) (Inter-American Development Bank) Venezuelan Trust Fund (1975) (Caribbean) Algerian Oil Fund

Authorized Released Capital Capital Plus Reserves Disbursements Liabilities 46,149

48,894

46,529

65,158

3,767

3,769

1,982

2,159

—

431.75

— —

— —

500 208 2,588 2,682 500 1,146 8,664 3,435 544 6,122 1,126 6,600 8,267

—

708 208 2,576 5,298 626 1,905 3,890 4,431 858 6,122 953 9,205 8,261

—

291 166 2,868 4,917 255 937 12,718 3,388 1,467 5,129 950 6,916 4,545

205.65

975.50

17,665.00 —

359 188 3,003 8,614 660 1,498 17,353 4,635 1,977 6,122 1,646 9,567 7,377

320.27

969.90

9,443.00 —

Sources: Traute Sharf, 1976; Hussein, 1982; Demir, 1979; Shihata, 1983; Achilli and Khaldi, 1984; Shihata and Sherbiny, 1985; Benamara and Ifeagwu, 1987; Abdulai, 1987; van den Boogaerde, 1990; OPEC Fund 1987; Abdulai, 1997. Notes: a. AAID = Arab Authority for Agricultural Investment and Development; AAD: Arab Accounting Dinar. b. AG FUND = Arab Gulf Program for UN development agencies; c. AMF = Arab Monetary Fund; d. BADEA = Arab Bank for Economic Development in Africa; e. AFTP = Arab Trade Financing Program.

to $73 billion (Table 3.6). Finally, throughout this period, official aid flows for the development of oil-exporting economies, referred to their GNP, varied between 4.0 and 5.0 percent annually against a mean of 0.5 percent for developed countries. Placement of this surplus had in fact two motivations: the greatest amount was invested, for economic reasons, in OECD countries and the rest, for political reasons, in developing countries. Widespread opinion at the time was that OPEC countries obtained enormous financial profits by investing their surplus in OECD countries, where investment opportunities were higher, technology was available, creditworthiness maximal, and security the best, while in developing countries conditions were the opposite.32

58

Two Crucial Problems

Figure 3.1 OPEC’s Current Surplus Evolution

Source: Oweiss 1984

The trade-off between these two motivations explains that eventually the bulk of OPEC’s current surplus went to OECD countries and not to developing countries, where financial needs were higher, thus favoring the placement scenario. The incapacity of developed countries to modify effective demand in favor of investment goods explains why these allocations—as shown above—did not entail real investment increases. The quick erosion of current surplus rapidly refuted the initially optimistic hypothesis in favor of the OECD. Developed countries could only perpetuate the financial nature of OPEC’s financial wealth. Yet what mattered for these countries was not to accumulate financial assets as such, but to transform this financial wealth into goods and services. With the passing of time it is probable that developing countries, with all their weaknesses, could have offered oil economies—and notably those with little absorption capacity—a real chance for this transformation to succeed. Current surplus melted down in 1978 and never again inflated accumulated surplus of those economies with little absorption capacity. In some cases, those economies faced with important current deficits (Saudi Arabia, for example) had to recur to their accumulated capital. The Gulf War drastically reduced capital held by approximately $200 billion. Considering current deficits and the cost of the Gulf War, the accumulated surplus (Appendix 3.1) for 1996, estimated at $65 billion, would have only approximated $300 billion in the best of cases. Thus ends the great petrodollar adventure together with the dream of external revenues coming to compensate future

Oil Export Revenues and Their Circulation

59

generations for the capital loss created by the exhaustion of nonrenewable resources. This definitely finished off recycling.33 Developing countries’ participation in financing raised on the international market remains weak today, with only some exceptions. Stock issuance increased while syndicated bank credits stagnated. Financing concerns only a small amount of countries. Thus, 55 percent of developing countries’ stock issuance in 1992 was carried out by four Latin American countries (Argentina, Brazil, Mexico, and Venezuela), and 35 percent by three Asian countries (Indonesia, Korea, and Thailand). Six Asian countries (Indonesia, Korea, Malaysia, Taiwan, China, and India) benefited in 1992 from more than half of syndicated bank credits. In 1992, the portion of accumulated capital assets since 1985 amounted to $562 billion against $6.2 trillion for the whole world (institutions included)—that is, somewhat over 8 percent or three or four times less than during the 1970s.34 This marked again the return to normal, that is, to the situation prior to the first oil shock. Oil Revenues and Development: Situation and Perspective

Erosion and the near disappearance of current financial surplus, insufficient structural change, economic and financial vulnerability, and increased external debt are today the lot of virtually all oil economies. Thus allowing for exceptions (Oman and Kuwait), the relatively sustained growth of the 1970s gave way to a marked weakening in the 1980s: 2.6 percent against 5.2 percent. The situation has not improved in these past years. Average annual growth rate dropped in 1990–1995 to 1.6 percent (Appendix 3.2). Industrial growth, which has been only slightly higher than the preceding, fell from 5.4 percent in the 1970s to 1.1 percent in the 1980s and to 2.0 percent in 1990–1995. Manufacturing-sector performance—still the engine for structural change—looks even more mediocre: 4.1 percent in the 1970s and 2.9 percent in 1980–1993. If agricultural performance looks good in the 1980s, it is partially due to Saudi Arabia’s, Kuwait’s, and the United Arab Emirates’ good agricultural development despite a very low starting level (Appendix 3.3). Nothing in these global and sector-based performances resembles the remarkable performance of semi-industrialized economies 35 in spite of record investment and savings rates. Annual average investment growth was 9.8 percent in the 1970s, and the mean gross savings rate was 39.5 percent (Appendix 3.4). The increased vulnerability of oil economies becomes evident due to a considerable divergence of import and export growth rates in the 1970s,

60

Two Crucial Problems

with import growth of 14.5 percent and export growth of –1.1 percent. With crude oil trade terms deteriorating and a drastic fall in the gross savings coefficient, import growth collapsed, showing –2 percent annually for the 1980–1993 period. Local production was incapable of a substantial takeover due to an insufficiently diversified local production and exporting system. At the period’s end this translated into a feeble participation by the manufacturing sector in the GNP.36 Outstanding external debt literally soared: $7 billion in 1970, $164 billion in 1980, and $269 billion in 1995. Countries like Indonesia, Nigeria, Egypt, Venezuela, and Algeria became heavily indebted, with exceptionally high debt-service charges. Net capital flows—outside Indonesia—weakened: $14 billion for Indonesia, but slightly over $3 billion for the rest, which shows a strong contrast with net capital flows toward emerging countries. The reasons for this situation and its multiple consequences—unemployment, economic, social and political instability, deindustrialization, and tutelage by the great international financial organizations—resulted from the macroeconomic logic of revenue economies whose characteristics have been historically described by Mahdavy (Iran), Seers (Venezuela), Lewis (nonpetroleum mining economies), and Sid Ahmed and Abdel Fadil (oil economies in general).37 The experiences of Australian mining, Dutch gas, and, subsequently, North Sea oil gave birth to the “Dutch disease” concept (the Dutch syndrome).38 Very schematically, this means that any important external boom gives way to the reevaluation of the national currency, discouraging the productive sector (commercial goods) and encouraging the speculative sector (noncommercial goods). The commercial sector contracts and gives rise to deindustrialization and even deagriculturalization phenomena that in turn halt the after-oil advent—that is, the transformation of financial wealth into real assets. These processes account for the essential problems faced by oil economies and the difficulties encountered in achieving internalization of the growth, for which Ali Fekrat described the absolute need.39 Numerous studies, based on concrete cases (including the Mexican one) have underlined the soundness of this type of diagnosis.40 There is no doubt that oil exporters (OEs) must review their development model in light of past experience and avoid oil revenues’ perverse effects. It is clear, however, that the oil exporters have paid a very high price to the world economy (especially to developed economies), just in terms of production levels, which turned out to be the source of distortion and damage to the exporters’ production systems. On top of it, they were mulcted. After having contributed generously to official aid for development, most of the oil-based economies are today in crisis, in debt, and facing dramatic economic, political, and social instability. They are more than ever affected by the structural vices of the international monetary and financial system and, finally, by the way the world economy operates.

Oil Export Revenues and Their Circulation

61

The debt burden must be lightened. This burden has strongly contributed to the stagnation and the economic crises in most OEs, and continues to do so. It also constitutes a significant deflationary factor at the international level and a great threat to the international financial system’s stability. The fundamental causes of this problem must be addressed. 41 These crises, in great part, weigh on OEs due to external shocks generated by the economic policies of the industrialized countries.42 The consequences of such policies have been mainly a soaring of interest rates, recession, and the collapse of oil trade terms. Petrodollar recycling had enabled most OEs with strong absorption capacity to transform short-term bank credits into long-term capital, to finance enterprises (often barely efficient because of the type of development chosen or induced by income prospects) or even invest in infrastructures of very long gestation. The lenders’ fault is undeniable here; they failed to really evaluate the borrowers’ creditworthiness, and with this goes the generally accepted idea that risks associated with loan operations are equally shared by lenders and borrowers.43 Clearly, it falls within the competence of the international monetary system to make a transition easier by granting adequate external financing to allow the OE economies to carry out necessary structural reforms and to return to normal growth. The G-24 has repeatedly put forward reasonable proposals for action to face the immediate aspects of the debt problem.44 Solutions had became clear from the moment the debt crisis was recognized as an external, reversible shock to the balance of payments in the case of OEs. By accepting the principle of the oil facility in the mid-1970s, the IMF implicitly admitted this concept of reversible, external shock. After the deterioration of crude oil trade terms during the 1980s, an inverse shock has become necessary, a shock that deserves at least an “oil counterfacility.” This oil facility principle led the G-24 in 1984, within the framework of the revised version of the 1979 action program, to propose the creation of a task force to work toward increased attention for the debt problem within the World Bank and the IMF.45 The G-24 ministers, moreover, underlined the need for cooperation among all those concerned with the debt problem, commercial financing flow and improved reconversion procedures, and a reasonable deduction in relation to export revenues regarding debt service. Versatile flows resulting from capital—a phenomenon aggravated by external financial liberalization46—strongly influence the world, as illustrated by the case of Mexico47 and, more recently, the Asian economies. Among the developing countries OEs are the most affected by the major developed countries’ economic policies.48 A report from the G-24 published in 1985 echoed the report published by G-10 in July of the same year that recognized that macroeconomic and international monetary policy

62

Two Crucial Problems

multilateral surveillance had not been as “effective as desired,” but accepted no reforms and recommended several measures on trade rates and surveillance. The G-24 specifically recommended adopting target zones and a narrower policy coordination among developed countries.49 Pressure would be exercised on those countries to carry out policies intended to correct the dreaded deviations from recommended policies and performance indicators. The pressures would come from the IMF, which would thus see to a more real symmetry, and this IMF surveillance would support growth, esspecially of developing countries. However, the IMF’s conditionality in the case of OEs, is embedded in programs that do not make economic growth a major priority. Therefore, a return to strong economic growth today constitutes a top priority for the majority of severely disrupted OEs, plunged at times in deep political and social crises, and of which Indonesia is but the latest example.50 Without questioning the IMF’s role as a balance-of-payments institution, it must be said that a lasting equilibrium for developing countries’ balance of payments fundamentally depends on the capability of those economies concerned to increase their growth in an enduring way.51 The case of OEs with weak absorption capacity, the long term included, deserves specific attention. The erosion of accumulated financial assets in the OE economies should induce the consideration of lessons of experiences such as those of Singapore or Hong Kong. The Arab emirates do not suffer the ills that affect the poorest developing countries, and they have an educated and disciplined work force that makes growth through exports predictable—but their economies’ weaknesses, in terms of labor scarcity and local market, must be taken into account in all strategic formulations for industrial development. Countries like Kuwait have entrepreneurial capacity and economic and social infrastructure to allow rapid industrial growth. It is therefore clear that this strategy, which applies to Asian countries too, must be directed toward international markets. It is a question of basing the strategy for development on international comparative advantage rather than on the endowment of a single resource, that is, to favor high-energy and capitalintensive products. It is a matter of these economies’ taking advantage of the creation of human capital—with its added value—and efficient communication networks to further the emergence of such financial centers as Kuwait in the world. Comparative dynamic advantages are evident in such industries as chemicals and engineering, as well as in the creation of the Gulf Cooperation Council to undertake a start of regional specialization.52 There is one last crucial problem for OEs: strong uncertainty due to fiscal policies, 53 when putting into practice the UN Convention on Climatic Change and the recommendations of the Kyoto Conference, real “de facto conventions on energy,”54 inasmuch as they target only oil without

Oil Export Revenues and Their Circulation

63

justification. Such targeting results in more energy taxes, discrimination against oil, and the encouragement of renewable energy sources despite their costs. Recent estimates from the OPEC World Energy Model suggest that OPEC countries could collectively lose approximately $20 billion per year due to these measures.55 For a long time OPEC countries have proposed a proportional system, with an equitable treatment of all carbonbased energy sources, that would (on the assumption that the OECD’s energy taxes were restructured according to this system) result in the reduction of carbon emissions by at least 10 percent, without any losses for the states concerned, and allow the reduction of oil taxes.56 There is still room for financial mechanisms, including real compensation, to mitigate the adverse economic effects of the Kyoto Conference proposals on developing countries that depend on the production and exportation of fossil fuels.57 In the short and medium term, oil demand will keep on growing, not only with the continuing and increasing demand from the developed countries but also from developing countries. 58 In the long term total oil demand should rise to 86 million barrels per day (bbl/day) in the year 2010. The bulk of this demand must be met by OPEC countries, and this implies considerable investment by these countries: $160 billion overall to increase their production capacity by 12 million bbl/day. From now until 2010 $215 billion will have to be invested for a supplementary capacity of 14.6 million bbl/day.59 Because OEs depend more than ever on oil revenues (which have been falling in real terms) for their development, such risky investments seem difficult in the OEs’ present economic and financial situation. This is not to mention the lack of ensurance of continued demand for the OEs’ main product. Increasing oil production and export supposes the existence of an international economic environment favoring economic development, investment, and free and open trade with true and impartial environmental protection. It is clear that world energy security would be better served by an OPEC in a position to ensure the increase of necessary production capacity, which means proper remuneration capable of guaranteeing regular revenues to producers and a reasonable yield to investors in the oil industry and, reasonably in the world market. In conclusion, it must be admitted that the considerable hope placed by OEs in their development resulting from hydocarbon fuel exports was largely frustrated by the slight progress made by most of them in structural changes. More than ever, now these economies depend on capital, technologies, and foodstuffs from the North. The chapter of oil revenues’ exuberant rise is already a parenthesis in recent economic history. Current surplus recycling in industrialized economies did not generate the profits expected, and, worse, that surplus was eroded. The enormous investments made domestically, far from producing the effects envisaged (i.e., preparation for after-oil development), produced perverse effects, which became

64

Two Crucial Problems

an obstacle to achieving this development. The most developed among the OEs, Indonesia and Mexico, once considered examples of successful outcomes, are today caught in the whirlwinds of volatile capital movements that disrupt violently development prospects. From Algeria to Indonesia, and from Mexico to Venezuela, the external debt was partly created to increase hydrocarbon fuel production capacity to satisfy expanding world demand. Big industrialized countries’ policies in the 1970s and 1980s made this debt heavier, creating a “debt overhang.” This debt is an obstacle to all enduring growth dynamism. OEs have been directly hit by the external countershock of hydrocarbon fuel prices’ collapse in nominal and real terms from the beginning of the 1980s. In spite of this situation, however, OEs have shown great solidarity with other developing countries— even though some of the former have been very reticent in minimum financial surplus recycling toward the latter in spite of the example of OPEC’s Algerian-Venezuelan Bank Project.

—

38.5

0.2

3.4

14.3

0.9

—

2.8

6.9

2.4

7.6

—

—

—

26.5

—

1.8

11.9

0.5

—

2.1

4.5

2.9

2.8

—

—

—

13.4

—

1.6

—

0.9

—

0.7

6.1

4.0

0.1

—

—

—

4.7

10.0

41.5

2.6

5.1

8.2

15.3

14.5

—

3.0

—

0.2

60.1 105.1

0.3

5.2

10.2

1.2

1.6

3.7

14.0

11.1

11.9

0.9

—

—

68.7

4.0

9.2

39.6

2.3

—

—

13.6

—

—

—

—

0.09

26.2

—

7.0

7.5

1.1

—

—

4.9

—

5.7

—

—

—

25.6

4.4

5.2

—

0.4

—

—

5.3

—

0.3

—

—

—

19,2

4.6

7.4

—

0.8

—

—

6.4

—

—

—

—

0.07

20.9

3.3

6.9

—

0.5

2.6

1.9

4.7

—

—

—

—

1.0

106.9 128.4 141.6 134.8 200.0 282.6 261.0 205.3 159.2 148.8 129.5

34.4

2.1

58.4

3.9

3.3

14.3

1.1

—

0.3

5.9

2.7

4.7

4.3

20.8

1.2

5.2

2.5

7.3

1.9

10.6

—

0.2

0.1

—

0.4

76.9

7.9

—

2.3

—

—

—

—

5.6

—

—

—

—

—

2.1

4.5

—

—

1.0

—

9.1

2.8

—

—

—

—

7.1 19.5

—

2.5

—

—

—

—

4.6

—

—

—

—

—

26.8

8.2

5.2

—

0.3

4.9

2.2

3.8

0.5

0.3

—

—

1.4

7.3

1.7

1.6

—

—

1.2

0.5

—

—

—

—

—

2.3

6.2 2.7

— —

3.0 0.1

— —

— —

2.2 —

— —

— 2.1

— —

— —

— —

— —

1.0 0.5

92.9 86.6 107.5 147.0 127.3 132.0 120.2

18.9

—

4.0

—

—

—

—

4.5

2.3

—

—

—

0.14

1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 19921993 Totals

Algeria — 0.2 7.3 Ecuador — — — Indonesia — — 4.1 Iran 1.0 4.9 54.8 Iraq 0.4 — 45.5 Kuwait 1.5 6.7 140.2 Libya — 1.0 25.9 Nigeria 0.2 2.1 26.1 Qatar 0.1 — 18.2 Saudi Arabia 3.1 0.2 163.4 United Arab Emirates 0.8 6.3 104.03 Venezuela — 7.3 51.2 Total 7.1 28.7 652.4 Total oil revenues

Country 1996

Appendix 3.1 OPEC Countries’ Financial Surplus, 1973–1996; Accumulated Surplus, 1973–1996; and OPEC Total Oil Revenues (in billions of dollars)

120.4

10.6

2.4

0.3

—

—

—

—

3.0

—

4.9

—

—

—

1994

132.1

7.2

1.6

1.2

—

—

—

—

4.4

—

—

—

—

—

1995

494 132 111 11,475

6,359 5,280 195 884 2 219 4,158 n.a. n.a. n.a. 10,738

1974

754 944 –32 7,937

3,492 458 1,967 1,067 498 1,652 629 44 –514 1,099 6,271

1975

515 2,480 –6 11,109

3,970 –1,044 4,253 761 419 1,828 1,903 802 –488 1,589 8,120

1976

8 392 –10 7,361

4,426 –825 4,320 958 736 1,408 401 328 18 55 6,971

1977

218 51 110 354

–2,311 –938 –1,499 126 702 792 792 –74 880 –14 –25

1978

–308 –988 19 7,087

2,102 3,341 –1,155 –83 508 672 5,083 1,930 215 2,937 8,364

1979

120 630 285 14,144

11,018 1,380 8,188 1,450 2,049 1,202 –1,160 –28 41 –1,172 13,109

1980

–208 723 2,864 16,474

12,147 –522 10,861 1,808 1,665 1,152 –1,869 –1,578 944 1,235 13,095

1981

–265e 644e 716e 12,395

7,125 380 6,887 –142 635 379 4,411 812 5,168 55 11,280

1982

1,954 4,504 3,528 78,442

40,297 7,496 26,595 6,207 6,512 9,231 12,416 3,036 3,169 6,211 68,456

Year End 1981

1,689e 5,168e 4,244e 90,837

47,422 7,876 33,482 6,065 5,877 9,610 16,827 2,224 8,337 6,266 79,736

Year End 1982b

Source: U.S. Department of the Treasury, Office of International Banking and Portfolio Investment, International Capital Reports, 1 March 1983. Notes: a. Figures have been rounded; b. Preliminary; c. Excludes negotiable time certificates of deposit that are included in “Other” liabilities; d. Organization of the Petroleum Exporting Countries plus Bahrain and Oman; e. Data as of September 1982; f. Organization of the Petroleum Exporting Countries; g. Position consists of cumulative flows from 1972.

Nonbank liabilitiesd U.S. government liabilitiesfg Direct investmentf Total invested

Government securities Treasury bills/certificates Treasury bonds/notes Federal agency issues Corporate bonds Corporate stocks Bank liabilities Demand deposits Time depositsc Other Subtotal

Investment position

Appendix 3.2 Oil Exporter Countries: Investments in the United States, 1974–1982 (in millions of dollars)a

5.2

4.6 7.3 7.2 9.5 4.6 — 3.5 6.3 6.2 9.0 –0.2 — 9.0 5.9 —

2.6

16.0 5.0 6.1 2.0 2.8 — 1.1 1.0 8.3 –1.2 12.2 –2.0 0.5 –2.5 —

1.6

1.6 1.3 7.6 3.4 0.1 — 2.4 1.1 6.0 1.7 — — –2.5 1.0 —

2.3

–0.1 — 4.1 2.8 7.5 — 3.4 3.2 — 5.7 7.5 — — –1.4 —

Agriculture

4.4

3.3 1.5 3.4 4.4 4.6 — 3.0 0.6 7.9 13.4 14.7 9.6 1.7 –5.8 — 1.0

2.3 2.1 2.9 2.5 1.3 — 1.9 0.4 — — –2.4 — –0.2 1.3 —

7.3 — 9.6 13.9 3.8 — 0.5 7.2 — 8.6 1.0 — — 5.6 —

Industry

–1.2 0.4 10.1 4.9 –1.1 — 3.4 0.5 — — — –1.8 2.7 0.2 —

Manufacture

5.4

1.1

–0.1 2.6 6.9 1.2 2.3 — 1.6 1.0 10.3 –2.3 — –4.2 1.0 –5.5 — 2.0

4.1

5.3 — 14.0 10.5 7.6 — 5.7 7.0 — 6.9 — — — 1.7 —

2.9

— — 11.8 0.3 –2.2 6.0 1.3 2.1 17.2 — — 2.7 8.7 –6.7 —

1970–80 1980–90 1990–95 1970–80 1980–90 1990–95 1970–80 1980–90 1990–95 1970–80 1980–90

Source: World Bank, World Development Report, 1997.

Total annual mean growth

Nigeria Egypt Indonesia Ecuador Algeria Iran Venezuela Mexico Oman Saudi Arabia Kuwait United Arab Emirates Gabon Trinidad and Tobago Qatar

Country

GNP

Appendix 3.3 Developing Country Oil Economies’ Growth Performance, 1970–1995 (annual growth in %)

1.4 –1.7 –1.3 0.1 1.1 –10.5 –6.8 5.5 –1.9 4.4 –8.3 6.3 0.1 –5.0 — 3.7

1.1 4.2 10.8 7.4 0.2 — 4.9 6.8 — — — — 4.1 12.5 —

Source: World Bank, World Development Report, 1997.

2.8

–0.3 5.2 2.9 5.4 4.1 — 2.8 6.6 — — –2.3 0.0 2.8 8.9 —

1970–80 1980–90 1990–95

Total annual mean growth –1.1

Nigeria Egypt Indonesia Ecuador Algeria Iran Venezuela Mexico Oman Saudi Arabia Kuwait United Arab Emirates Gabon Trinidad and Tobago Qatar

Country

Exports

14.5

18.8 9.6 4.5 10.3 13.1 12.5 10.8 7.9 28.3 35.3 16.0 28.2 11.9 –3.7 —

1970–80

–2.0

–11.2 –1.5 4.5 –2.2 –5.1 — –3.6 6.7 1.2 –5.5 –4.4 1.9 –1.6 –8.0 —

1980–93

Imports

9.8

11.4 18.7 14.1 11.0 13.6 6.9 7.1 8.3 — — 19.4 — 13.6 14.2 — –2.9

–8.6 2.7 7.0 –3.8 –2.3 — –5.3 –3.1 — — –4.5 –8.7 –4.6 –10.1 — 1.3

1.2 –1.5 16.3 5.3 –4.7 — 3.8 –1.2 — — — — –0.5 0.1 —

1970–80 1908–90 1990–93

Gross Internal Investment

Appendix 3.4 Oil Economies: Evolution of External Investment Changes, 1970–1995, Exchange Terms (mean growth in %)

39.5

32 15 37 26 43 — 3.3 25 47 62 58 72 61 42 —

1980

23.3

20 6 3.6 21 29 — 21 19 27 30 18 2.7 48 25 —

1995

Gross Internal Savings

148

167 147 145 143 173 — 166 145 182 175 165 181 154 138 —

1985

79

85 95 79 71 83 — 82 92 77 92 88 93 90 86 —

1995

Exchange Terms

27,759 6,516 24,878 2,975 14,500 — 22,232 3,852 114,208 27,344 — 2,434 3,371 250,039

1980

9,879 11,357 52,505 5,298 10,954 — 22,406 6,403 55,091 19,276 — 2,793 2,875 198,837

1995 22,005 9,745 25,694 3,647 14,552 — 17,065 2,650 62,710 10,463 — 1,926 2,972 173,429

50,427 17,353 60,367 6,351 12,512 — 20,262 5,671 45,583 13,232 — 2,415 2,577 236,750

1995

Goods and Services Imports and Revenues

1980

Source: World Bank, World Development Report, 1997.

Nigeria Egypt Indonesia Ecuador Algeria Iran Venezuela Oman Saudi Arabia Kuwait United Arab Emirates Gabon Trinidad and Tobago Total

Country

Goods and Services Exports and Revenues

Appendix 3.5 Oil Economies: Economic and Financial Indicators (in millions of dollars)

— — — — — — –418 –362 –4,094 –692 — –143 — –6,489

1980 — — — — — — –173 –1,740 –16,616 –1,347 — –152 — –20,028

1995

Net Workers’ Funds Transfers –166 — — — — — — — –5,901 –888 — — –43 –6,998

1980 –1,894 — — — — — — — –1,000 –499 — — –35 3,428

1995

Other Private Net Transfers 5,178 –438 –566 –642 249 — 4,728 942 41,503 15,302 6,862 384 357 73,859

1980

–510 –956 –7,023 –822 –2,310 — 2,255 –979 –8,108 4,198 –4,632 378 294 –18,215

1995

Current Transactions Balance

10,640 2,480 6,803 1,257 7,064 — 13,360 704 26,129 5,425 31,755 115 2,813 119,185

1980

1,709 17,122 14,908 1,788 4,164 — 10,715 1,251 10,399 4,543 49,144 153 379 116,295

1995

Gross International Reserves

1970

8,921 19,131 20,938 5,997 19,365 — 29,344 — 599 — — — 1,514 829 164,076

1980

35,005 34,116 107,831 13,957 32,610 — 35,842 — 3,107 — — — 4,492 2,556 269,516

1995 10.1 89.2 28.0 53.8 47.1 — 42.1 — 11.2 — — — 39.2 14.0 —

1980

External Debt in GNP %

Source: World Bank, World Development Report, 1997.

Nigeria 458 Egypt 1,760 Indonesia 2,447 Ecuador 19.4 Algeria 941 Iran — Venezuela 729 Iraq — Oman — Saudi Arabia — Kuwait — United Arab Emirates — Gabon — Trinidad and Tobago — Total —

Country

External Debt

1,405 73.3 56.9 84.1 83.1 — 49.0 — 29.5 — — — 121.6 53.6 —

1995

32.1 207.7 — 201.6 129.9 — 132.0 — 15.4 — — — 62.2 24.6 —

1980

External Debt in % of Goods Exports and Services

Appendix 3.6 Oil Economies: External Debt, Characteristics and Private Capital Flow

274.5 28.1 202.9 263.4 264.2 — 160.0 — 48.2 — — — 160.3 87.9 —

1995

4.1 13.4 — 33.9 27.4 — 72.2 — 64 — — — 17.7 6.8 —

1980

Debt Service in % of Goods Exports and Services 12.3 14.6 30.9 26.7 38.7 — 21.7 — 7.5 — — — 15.8 14.8 —

1995

453 294 11,648 561 129 — 848 — 126 — — — —125 271 14,205

1995

Private Capital Net Flow (in millions of dollars)

Oil Export Revenues and Their Circulation

Notes

71

1. Robert Sollow, “The Economics of Resources or the Resources of Economics,” The American Economic Review (May 1979). 2. Thus in Kuwait, the country’s strong inclination to save, resulting from a limited domestic capital absorption, was in the 1950s and 1960s on average around 42 percent of GNP. See Raggaei El Mallak, Economic Development and Regional Cooperation: Kuwait (Chicago: Chicago University Press, 1968). 3. For more details, please refer to developments on this matter in Abdelkader Sid Ahmed, 1983, p. 129 and remainder. 4. Ibrahim M. Oweiss, “Petrodollar Surplus: Trends and Economic Impact,” The Journal of Energy and Development 9, 2 (Spring 1984): 177–203. 5. This particularly worrisome phenomenon, when the dollar weakened against strong European currencies and the yen, was the basis of several OPEC debates aimed at developing specific price mechanisms. For evidence in figures of losses resulting from the dollar, see the study made by Saudi Arabia and the other OPEC countries in Ronald Cooper, “Changes in Exchange Rates and Oil Prices for Saudi Arabia and Other OPEC Members,” Journal of Energy and Development 20, 1 (Autumn 1994): 109–129. 6. John Makin, A. Sherbiny, and M. Tessler, “International Financial Implications of Increased Flows of Funds to and from Petroleum-Producing Countries,” 1976, pp. 177–201. 7. Ibrahim M. Oweiss, “Petro-Money: Problems and Prospects,” in Inflation and Monetary Crisis, ed. G. C. Weingard (Washington, D.C.: Public Affairs, 1975). 8. Jan Tumlir, “Oil Payments and Oil Debt in the World Economy,” Lloyds Bank Review, 113 (July 1974): 1–15; Hazem Beblawi, Oil Surplus Funds: The Impact of the Mode of Placement, OPEC Fund (1984). 9. Ibid. 10. Wall Street Journal, “Company Executives Shore Up Defenses Against Take-overs” (21 October 1974); Michael Field, A Hundred Million Dollars a Day: Inside the World of Middle East Money (London: Sidgwick-Jackson, 1975). 11. Figures obtained from several issues of Rapport sur le développement dans le monde de la Banque mondiale and Manuel de statistiques du commerce international et de developmant, UNCTAD, various years. 12. Bank for International Settlement (B.I.S.), 1982. 13. Stephany Griffith-Jones and Osvaldo Sunkel, Debt and Development Crises in Latin America: The End of an Illusion (Oxford: Clarendon Press, 1986). 14. P. Atkinson and J. C. Chouraqui, “The Origins of High Real Interest Rates,” OECD Economic Studies 5 (1985). 15. Beblawi, Oil Surplus Funds. 16. Let us specifically quote the following innovations intended to reduce Eurobanks’ risks on developing countries: rollover credits based on floating interest rates (Libor and North American Prime Rate) plus a margin (spread), sensibly reflecting market liquidity and borrower credibility in addition to management and commitment commissions. 17. W. Brown and H. Kahn, “Why OPEC Is Vulnerable,” Fortune, 14 July 1980. 18. See Walter H. Levy, “The Days That the Locust Had Raten: Oil Policy and OPEC Development Prospects,” Foreign Affairs (Winter 1978): 287–306. 19. R. Pringle, “Re-cycling in the 1980s: IMF’s Role,” The Banker (July 1980): 19–25; A. Stoga and P. Benett, “How Fast Is OPEC’s Surplus Disappearing?” The Banker (September 1981): 115–121; Abdelkader Sid Ahmed, “Energie et

72

Two Crucial Problems

développement de la confrontation au dialogue,” Revue d’économie politique 5 (1981): 624–650; J. Amuzegar, Oil Exporter’s Economic Development in an Interdependent World, IMF, Occasional Paper 18 (Washington, D.C.: 1983). 20. Oweiss, “Petrodollar Surplus.” 21. Thus in 1989 the North American deficit went to $111 billion and that of the OECD zone went globally to $83 billion. 22. UNCTAD, Trade and Development Report, Geneva 1992. 23. Michael Stewart, “Massive Transfers of Resources: Mechanisms and Institutions,” in Development Financing: A Framework for International Financial Cooperation, ed. Salah Al Shaikhly (Boulder, Colo.: Westview Press, 1982), 111– 129. 24. Nicholas J. Robinson, “The Role of Oil Funds Re-cycling in International Payments and Adjustment Problems,” OPEC Review 4, 2 (Summer 1980): 98– 110. 25. Soliman Demir, Arab Development Funds in the Middle East (Oxford, UK: Pergamon Press, 1979); Ibrahim Shihata, The OPEC Fund for International Fevelopment: The Formative Years (London: Croom Helm, 1983); A. Benamara and S. Ifeegwu, OPEC Aid and the Challenge of Development (London: Croom Helm, 1987); P. Van Den Boogaerde, The Composition and Distributions of Financial Assistance from Arab Countries and Arab Regional Institutions, IMF Working Paper (Washington, D.C.: 1990); and OPEC Fund, OPEC Aid Institutions: A Profile (Vienna, 1997). 26. Shihata, The OPEC Fund for International Development. 27. Abdelkader Sid Ahmed, “The Role of the New OPEC Development Agency,” in Development Financing: A Framework for International Financial Cooperation, ed. Salah Al Shaikly (Boulder, Colo.: Westview Press, 1982), 15–33. 28. Shihata, The OPEC Fund for International Development. 29. Donald Bobiash, South-South Aid: How Developing Countries Help Each Other (New York: St. Martin’s Press, 1992). 30. UN General Assembly, “Caracas Program of Action,” A/36/33, 26 June 1981, 14. 31. Benamara and Ifeegwu, OPEC Aid and the Challenge of Development. 32. Beblawi, Oil Surplus Funds. 33. It must be recalled that direct transfers on account of those diverse OPEC institutions mentioned still remain, as do the salaries paid to developing countries’ expatriates (more than $20 billion in total for Venezuela, Oman, Kuwait, and Saudi Arabia). However, salaries paid to developed countries’ expatriates must be subtracted from this amount (Appendix 3.5). 34. UNCTAD, 1993. 35. Korean economic growth was 9.4 percent in 1980–1990 and 7.2 percent in 1990–1995; Thailand’s 7.6 percent and 8.4 percent; Turkey’s 5.3 percent and 3.2 percent; Chile’s 4.1 percent and 7.3 percent; Colombia’s 3.7 percent and 4.6 percent; China’s 10.2 percent and 12.8 percent; etc. 36. GNP manufacturing added value was 5 percent for Nigeria in 1995; 9 percent for Algeria; 17 percent for Venezuela; 11 percent for Kuwait; 8 percent for the United Arab Emirates; with 24 percent for Indonesia as an exception. Inversely, one finds 27 percent for Korea in 1995; 21 percent in Turkey; 24 percent for Brazil; 18 percent for Colombia; 23 percent for the Philippines; and 24 percent for Peru. See Trade and Development Report, UNCTAD, 1997. 37. For more details, refer to Abdelkader Sid Ahmed, Economie de l’industrialisation à partir des ressources naturelles, vol. 2, Le cas des hydrocarbures (Paris: Publisud, 1989).

Oil Export Revenues and Their Circulation

73

38. Enders and Herberg, 1983, Corden. 39. Ali Fekrat, 1979. 40. Abel Beltrán Del Rio, “The Mexican Oil Syndrome: Early Symptoms, Preventive Efforts, and Prognosis,” The Quarterly Review of Economic and Business (Summer 1981): 115–130; Robert E. Looney, “The Mexican Oil Syndrome: Current Vulnerability and Longterm Viability,” OPEC Review 9, 4 (Winter 1985): 369–388; A. Gelb, Oil Windfalls: Blessing or Curse (London: Oxford University Press, 1988); Abdelkader Sid Ahmed, Development and Resource-Based Industry: The Case of the Petroleum Economies, OPEC Fund, pamphlet series 28 (Vienna, 1990); P. Daniel, “Economic Policy in Mineral-Exporting Countries. What Have We Learned?” in Mineral Wealth and Economic Development, ed. J. F. Tinton (Washington, D.C.: Resources for the Future, 1992); Mahon, 1992; R. M. Auty, Sustaining Development in Mineral Economies: The Resource Curse Thesis (London: Routledge, 1990); Auty, 1993, 1994; Evan and Auty, 1994. 41. Arturo O’Connell, “External Debt and the Reform of the International Monetary System,” CEPAL Review 30 (1986): 51–67. 42. Edmar Bacha, “I.M.F Conditionality: Conceptual Problems and Policy Alternatives,” World Development 15, 12 (1987): 1457–1467; Rab Vos, Debt and Adjustment in the World Economy, Structural Asymmetries in North-South Inter actions (New York: St. Martin’s Press, 1994). 43. D. Khatkhate, “International Monetary System, Which Way? Editor’s Perspective,” World Development 15, 12 (December 1987): 7–16. 44. Randall Henning, “The Group of Twenty-four: Two Decades of Monetary and Financial Cooperation Among Developing Countries,” International Monetary and Financial Issues for the 1990s 1 (New York: United Nations, 1992), 137– 153. 45. Group of Twenty-four, Revised Program of Action Towards Reform of the International Monetary and Financial System, Washington, D.C., September 1984. 46. For more details on the implications, see D. Felix, “International Capital Mobility and Third World Development: Compatible Marriage or Troubled Relationship?” Policy Science Review 27 (1994): 365–394; Lance Taylor, “Financial Fragility: Is an Etiology at Hand?” in New Perspectives in Macroeconomics, G. Dymski and R. Pollin, eds. (Ann Arbor: University of Michigan Press, 1995); S. Hoggard and S. Maxfield, “The Political Economy of Financial Internationalization in the Developing World,” International Organization 50 (1996): 35–68. 47. On the increasing constraints set by the growing role of portfolio investments in developing countries, from the Mexican case, see I. Grabel 1996. 48. Akyzüz, “On Financial Openness in Developing Countries,” in UNCTAD, 1993, 111–124; I. Grabel, “Speculation-led Economic Development: Toward a Post-Keynesian Interpretation of Financial Liberalization Programs in the Third World,” International Review of Applied Economics 9, 2 (1995): 127–149; I. Grabel, “Assessing the Impact of Financial Liberalization on Stock Market Volability in Selected Developing Countries,” The Journal of Development Studies 31, 6 (August 1995): 903–918. 49. For more details see Williamson, 1978; and Kenen, 1987. 50. Abdelkader Sid Ahmed, “L’économie politique de la transitions au Maghreb: l’industrialisation revisitée, les limites du modèle F.M.I.-Banque mondiale,” in Méditerranée, nouveaux défis, nouveaux risques, eds. J. F. Daguzan and R. Girardet (Paris: Publisud, 1995), 167–256; Dabt, 1996. 51. Ismail-Sabri Abdallah, “The Inadequacy and Loss of Legitimacy of the I.M.F.,” Development Dialogue 2 (1980): 25–53; Bird, 1982; Bacha, “I.M.F. Conditionality”; G. Bird, “The Myths and Realities of I.M.F. Lending,” World Economy

74

Two Crucial Problems

17 (September 1994); T. Killick, “Can the I.M.F. Help Low-income Countries? Experiences with Its Structural Adjustment Facilities,” World Economy 4 (July 1995); G. Bird, “Borrowing from the I.M.F.: The Policy Implications of Recent Empirical Research,” World Development 24, 11 (1996): 1753–1760. 52. See Girgis, 1984; and K. H. Farzin, “Importance of Foreign Investment for the Long-run Economic Development of the United Arab Emirates,” World Development 21, 4 (1993): 509–521. 53. See Adam Seymour and Robert Mobro, Energy, Taxation and Economic Growth, The OPEC Fund, pamphlet series, no. 30 (Vienna, 1994). 54. Rilwanu Lukman, “Assessing International Energy Security: Problems and Prospects,” OPEC Bulletin (September 1997): 4–5. 55. Shokri Ghanem, “Climate Change and Measures to Combat It: The Question of Compensation,” OPEC Bulletin (November 1997): 4–5. 56. Ibid., OPEC Fund, OPEC Aid Institutions (1997). 57. Riad Daoudi, “Reduced Fossil Fuel Exports as a Result of the Climate Change Treaty: The Legal Aspects of Compensation,” OPEC Bulletin (1997): 6–11; Ray Julian Spradley, “Structuring a Compensation Mechanism for Developing Countries Affected by Climate Change and Remedial Measures,” OPEC Bulletin (November 1997): 12–15. 58. C. H. Tahmassebi, “World Oil Markets: The Long Term Outlook and Implications for OPEC,” Middle East Executive Reporters (June 1994); Hooshang Amirahmadi, “World Oil Geopolitics to the Year 2010,” The Journal of Energy and Development 21, 1 (Autumn 1995): 85–123. 59. Lukman, “Assessing International Energy Security: Problems and Prospects.”

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4 The Recycling of Petrodollars Francisco García Palacios

The 1970s, the decade in which the Intergovernmental Group of 24 on International Monetary Affairs (G-24) emerged, was a period of financial turbulence that saw the disintegration of the international monetary system that had been established at Bretton Woods and the transition to a new monetary order under conditions of exceptional economic instability. It was a time of widespread distortions, characterized by severe imbalances on external accounts and the appearance of the phenomenon of inflation in the midst of stagnation. This combination of woes, unknown until then, emerged early in 1973 following a long period of economic boom, excessive pressures on primary-product markets, the collapse of the fixed-parity system, and the adoption of floating rates of exchange. The singular aspect of these years was the rise in prices of primary products, which reached levels unprecedented since the Korean War. In some cases the situation was aggravated by interruptions in supply, which provoked violent increases in the prices of some food items and in oil. Oil prices quadrupled between October 1973 and January 1974, thus ending the era of cheap oil that had lasted since World War II. This sudden and substantial price increase resulted in a massive redistribution of income to oil exporters and in a new challenge for the international community due to the impact on the world economy. Because oil is the principal source of energy, the price rise brought significant repercussions to the industrialized countries given their high consumption and limited production. Developing countries had to satisfy their oil requirements either partially or totally on the external market, weakening their economies and disrupting their political solidarity with the principal exporters, which also belonged to the group of nations struggling to overcome economic backwardness. Oil Prices and International Transactions

The increase in oil prices profoundly altered the traditional flow of international payments and had important repercussions in the financial structure 81

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and performance of the world economy. The increase also sowed doubts about the traditional system of international trade in which developing countries always had current-account deficits and the industrialized nations surpluses, which meant there was a net transfer of capital goods, technology, and other real resources necessary for progress. Further, the transfer of real resources needed to sustain development ceased to be a merely financial matter related to the investment flows and loans that produce these transfers. The alternative was now to achieve development by increasing income from exports by following the example of the member states of the Organization of Petroleum Exporting Countries (OPEC). For different reasons, the aspiration to stimulate development through exports had not been successful, due largely to difficulties in improving the terms of trade for basic products in the long term. What happened with oil demonstrated the power of relative prices in the transfer of real resources, and opened the possibility of similar acts by other exporters of raw materials which, if they had happened, would have transformed the entrenched pattern of international payments. By coincidence, the time seemed ripe for revaluing natural resources since there was widespread concern about the accelerated depletion of resources. This concern had been prompted by a number of studies, principally by the Club of Rome (1972), then corroborated by the oil crisis. Without a doubt, the steep rise in oil prices was a warning of the danger of the extravagant consumption of nonrenewable natural resources. In the short term the rise introduced a new challenge to the international financial system, whose performance would be crucial for growth and world inflation. Some will recall that institutions like the World Bank and the Organization for Economic Cooperation and Development (OECD) were making projections that by 1980 the accumulated surplus of the OPEC countries would be between $300 and $650 billion—astronomical amounts even now. These and other similar calculations gave the impression that the world was facing a structural shake-up of international payments, requiring an adjustment process extending over at least a decade to enable oil importers and exporters to adapt without trauma to the new energy situation. In the meantime the only remedy was to finance the external imbalances. The perception that the world was facing a structural problem was based on the apparent inability of the oil countries to assimilate their sudden wealth and on the serious limitations of the traditional policies for correcting external deficits. The former was attributed to obstacles to the expansion of productive investment and consumption. These obstacles blocked the return of the additional income to the rest of the world, by means of an equivalent increase in imports. The latter reflected heavy dependence on oil and the consequent ineffectiveness of the conventional measures of external adjustment, which would simply have transferred the

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problem from one country to another, with the danger of precipitating another world depression. Nor could the global imbalance be moderated by shifting oil demand to countries with greater absorption capacity because faster depletion of the oil in these countries would compromise their future development, and because there were the political and economic implications of concentrating this strategic resource in a small group of countries. On the supply side nothing could be done to moderate the imbalances. Cuts in production to adapt to the absorption capacity of the exporters would have worsened the situation because the consequent rise in prices, coupled with the short-term inelasticity of demand, would have swollen their export receipts even more. Later, however, the high prices stimulated a more diversified supply, which produced a marked erosion in the terms of trade in the oil market and the disappearance of balance-of-payment problems. For the time being, little could be done to eliminate the inflexible conditions, and any effort to reestablish international equilibrium in the short run would have been prejudicial for all sides. The best course was to move gradually to prevent a sudden generalized adjustment. Accordingly, the appropriate solution was to provide a temporary outlet for the additional income of the oil-exporting countries. A posteriori, the events revealed that the imbalance was less serious and rigid than initially thought. Even so, it was an urgent and serious problem at the time, even for the surplus countries. Several factors explain the marked divergence between predictions and results, especially the real trend in oil exports and purchases of goods and services abroad. Both variables reacted better than expected due to the profound alterations provoked by the abrupt rise in prices on the oil market, which made the extrapolation of past trends inappropriate for predicting the near future, and even less so in the medium and long term. Proof of this is the decline in the importance of oil as a source of energy, and above all the appearance of exporters outside OPEC. On the import side, absorption by the surplus countries was severely underestimated due to the unexpected expansion of domestic spending and the unsuspected latent demand for armaments that the arms-producing countries were ready to satisfy. The latter were convinced that it would strengthen their influence on OPEC members and guarantee access to their sources of hydrocarbon fuels. In any event, the structural problem of the balance-of-payments deficit did not awaken lasting interest, perhaps because of the usual tendency to pay more attention to urgent rather than important matters. And the most urgent matter was how to resolve the imbalances in the short and medium term. According to estimates by the IMF, the oil exporters’ current account would produce a surplus of about $70 billion in 1974 and 1975. As might be expected, these imbalances monopolized the attention of the international community and encouraged a short-term view of the problem. Although justified by later events, this focus was disadvantageous for the

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net-oil-importing developing countries. Such a focus discouraged the search for solutions in line with the countries’ capacity to adapt to the new conditions of the oil market and, as will be seen later, contributed to the foreign debt crisis. The situation of the oil-importing countries—unlike that of the exporters, which were all to some extent in surplus—was quite varied because not all had negative balances on their current accounts. Although the importing countries were a very diverse group, some common features can be identified. First, a few countries were able to use their own oil supplies and reduce their dependence on external sources of energy, while others were marginal net exporters. Second, some countries had comfortable surpluses and possibilities of absorbing the additional costs without difficulty. Last, the principal importers had a productive structure capable of offsetting the additional costs by exporting to the OPEC members, which they supplied with about 80 percent of their imports. Although some developing countries had oil potential, they did not have the productive flexibility of the industrialized countries and lacked close trading ties with the oil exporters; in addition, they normally maintained deficit current-account balances with the rest of the world. The trend in the external accounts transformed the customary surplus of the industrialized countries into an adverse balance of about $35 billion in 1974, in contrast to a favorable balance of over $3 billion in the preceding two years. Among the net-oil-importing developing countries, the deficit was $37 billion, compared with an average of $11 billion in the early 1970s. In quantitative terms, the higher cost of oil was felt most by the advanced countries, whose balance of payments suffered severe shortfalls despite the realignment of exchange rates in 1971 and 1973. The external deficit of the United States, which had provoked the collapse of the international monetary system, was showing a favorable trend by 1973, moving from a deficit of almost $10 billion to a more balanced position. This improvement was associated with the disappearance of the Japanese surplus, which had reached $7 billion in 1972, and the deficits of Italy and the United Kingdom, whose current accounts recorded negative balances of over $2 billion each in 1973. West Germany—traditionally a surplus country—even came out of the general adjustment strengthened with a balance in excess of $4 billion, a fivefold increase. Following the rise in oil prices, the distribution of balances worsened substantially because the principal consuming countries—the United States, Japan, and West Germany representing about two-thirds of the industrialized countries’ oil bill—managed to offset a large part of the oil effect through improvements in their balances with their other trading partners and sales to developing countries, including the oil exporters. Roughly, in 1974 the increase in the nonoil balance of these three countries was equivalent to over half the increase in the value of hydro-

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carbon imports of OECD member states. It was this factor that determined the favorable balance obtained by this group in relation to other net oil importers, chiefly developing countries (Table 4.1). Within the readjustment in international trade, the nonoil developing countries were hit by a more important and heavier burden. Even so, the more advanced countries with higher levels of energy consumption like Brazil and the Asian “tigers” were able to adapt with some flexibility to the new circumstances. And the consequences for the rest were less severe and in many cases were similar to those caused by higher prices for food imports, which affected the less developed countries of Africa, Latin America, and Asia. In short, the increases in prices had no lasting or uniform effects. This was because the increases were concentrated in countries with high levels of energy consumption and whose economies had sufficient room to reduce these costs and the capacity to respond to the oil imbalance by exporting to OPEC countries. Furthermore, the latter group had an unsuspected ability to make use of their windfall income. These factors in both groups of countries made the adjustment to the oil imbalance easier than had been thought possible and transformed the problem into a short-term difficulty; this was very different from the scenario first developed. Even so, the general imbalance was still overwhelming and would have been unmanageable without an appropriate financial response. Financing the External Imbalances

The surplus of the oil exporters and the deficit of the importers would not have been sustainable without compensatory financial flows. In the flows’ absence the adjustment on both sides would have been more rapid than it Table 4.1 Current Account of Industrialized Countries (billions of U.S. dollars) Country

West Germany Canada United States France Italy Japan United Kingdom Other OECD Total OECD

1972

0.8 –0.6 –9.7 0.3 2.3 6.6 0.3 3.4 3.3

1973

4.3 0.0 0.3 0.7 –2.4 –0.1 –2.1 3.9 3.3

Source: IMF Annual Reports and OECD Economic Outlook. Note: a. Current account without increase in oil prices.

1974

9.6 0.8 –3.4 –5.9 –7.8 –4.7 –8.6 –12.6 –34.5

1974a 15.9 –1.5 11.4 0.4 –2.8 7.3 –3.4 –3.4 23.9

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was in practice, and could have unleashed a world depression in the extreme case. In essence, financing was a means of ensuring that the increase in savings, the product of the redistribution of income to countries with a low propensity for consumption and real investment, would not precipitate a slump in economic activity in the oil-importing countries. This meant transferring present real resources—oil—in exchange for future goods and services in an effort to cushion the income redistribution process and make it less burdensome, since the return on the finance was lower than international inflation. In the short term, the increase in prices obliged exporters to dispose of the liquid assets they had accumulated abroad, generally as dollar deposits. The urgent question was the insufficiency or otherwise of international reserves to cover these deficits and the capacity of the international financial system to supply the additional payment means required by the countries. Liquidity was the critical variable because the level of international reserves was inadequate in relation to the expected imbalances, and, more seriously, its distribution did not favor the majority of net-oil-importing countries. At the end of 1973, these assets were held by a small group of surplus countries consisting of the United States, West Germany, and Japan, which held a third of total reserves. A similar amount was held by the rest of the developed countries together with the developing countries, including the oil exporters. In any event, the use of international reserves to cover oil deficits was not a viable solution because the reserves were required for other needs. Nor was it realistic to suppose that the oil countries would quickly become exporters of long-term capital through direct investment and loans. Longterm transfers were not, however, totally absent during the early years of the oil adjustment, usually taking the form of development loans. During the critical years, foreign investments and outflows of private capital had no significant effect on the basic balance of payments but over time they became factors of great importance, especially for exporting countries with less capacity for absorption and high oil reserves. Between 1973 and 1975 net official disbursements by OPEC countries on development loans rose from $1.8 to $8.2 billion, contrasting with the outlays by the industrialized countries that increased by slightly more than half in the same period. In terms of GNP, the transfers from the oil exporters doubled, from 1.4 to 2.7 percent, and remained in the region of 2.0 percent for the rest of the decade. At this level they easily exceeded the UN target (0.7 percent of GNP) and the contributions made by the advanced countries. But the most significant aspect was that some of the OPEC countries were less developed than many of the beneficiaries and the transfers came from the extraction of a nonrenewable resource. On the

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other hand, the loans made by the industrialized countries came from value added generated by productive factors. Another aspect of the increase in financial cooperation by the OPEC countries was their growing participation in multilateral operations rather than bilateral arrangements, which had been the prevailing modality in the past, usually limited to neighboring states. The preference for multilateral channels was a response to two general considerations: the political need to assist a wide range of countries and preserving the value of the loans. The first would have been difficult to achieve in the context of a bilateral policy since OPEC lacked the institutional infrastructure to efficiently undertake the task of financing development, and did not possess mechanisms for coordinating the individual efforts of its members. These limitations had not been very important in previous years when transfers were made as grants for specific interests. The new situation required a common response by OPEC members and a much greater volume of finance to have the desired effectiveness. In other words, the sacrifice had to be significant, but also short-lasting, since the funds would be required later for their own progress, as in fact happened when several OPEC countries had to resort to external borrowing to maintain their development process. One way of moderating the sacrifice was to channel the financing through multilateral institutions, such as the World Bank and regional organizations, and let these channel the funds into development promotion. Multilateral intermediation offered several advantages for the surplus countries, which had simultaneously to preserve their financial assets and contribute to strengthening the net-oil-importing developing countries. The attraction of the multilateral institutions was the security and return offered by the placements. The institutions enjoyed the backing of the industrialized nations and had never defaulted on their obligations, while the return was not much lower than on the private markets. But there were important disadvantages. First, the fact that the credit operations were designed for specific projects usually with an imported component did little to mitigate balance-of-payment difficulties. Second, the oil countries had little influence in the management of these institutions, preventing the channeling of the funds in line with their own interests. Last, and from the side of the industrialized countries (particularly the United States), there was little inclination to open spaces for the funds from the OPEC countries, and much less to grant them seats on the decisionmaking bodies of these institutions. To compensate for the shortcomings of the traditional development-finance institutions, OPEC members strengthened their individual mechanisms of cooperation and created the OPEC Development Fund in 1975. The purpose of this new organization was to consolidate members’ contributions in order to channel them to the oil importers most affected by

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international conditions as quickly as possible and in volumes that represented a significant relief for their external problems. This fund began operations in 1976 with about $4 billion in the form of interest-free commitments and contributions of capital. Most of these funds were used for relief of balance-of-payment problems and for joint financing of projects and programs with other international organizations. About a quarter of the funds related to grants and contributions applied to the IMF Trust Fund, and another important percentage went to the International Fund for Agricultural Development, where oil contributions played a crucial part in its creation and achieving the participation of the industrialized countries in the institution. The direct operations of the OPEC Development Fund were concentrated in the least developed countries of Africa, Asia, and Latin America, and continue to the present day. Until the second half of the 1970s, the transfers of real resources through direct investments and long-term finance made little contribution to the circulation of oil income, especially in comparison with the size of the current-account imbalances. However, it was an appreciable relief for a broad segment of less advanced countries affected by higher oil prices. It should be remembered that approximately 90 percent of developing countries imported less than $1 billion a year in oil, and half had an annual oil bill of under $100 million, implying that the transfers were more significant than the global amounts reveal. Anyway, accumulated external financial claims, other than international reserves, rose from slightly less than half the surplus in 1974 to about three-quarters in 1975 and became more important than accumulated reserves until the oil boom of 1979–1980. A very large portion of the surplus did not require effective payment. The export income never totally reached the countries because of the usual practice of credit sales and the custom of the oil companies, almost all multinationals, of returning to the host country only a portion of exports sufficient to meet tax obligations and local spending, both current and investment. In fact investment declined considerably in those years due to expectations of nationalization in several OPEC countries. There is no precise estimate of the effect of these factors on the inflow of funds, because of the different tax policies of the oil-producing nations, among other reasons. It can be inferred that about 20 percent of the value of exported oil was involved, which provided substantial relief for the balance-of-payment problem, although the relief was limited to the industrialized countries where the multinationals were located. There is nothing unusual in the discrepancies between export income and real movements of funds; it is simply a question of accounting methodology. This factor is often ignored but should be taken into account when examining the problem of the circulation of the petrodollars, where the important factor is cash flow and not the magnitudes produced by balance-of-payment accounting, which normally exaggerates borrowing requirements.

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International Liquidity

89

At the global level during the critical years, movements of capital were greater than expected but did not solve the problem of the lack of means of payment for the oil bill. Under these circumstances, the bulk of the imbalance had to be covered by the international reserves of the deficit countries and an increase in international liquidity. If it had not been for the expansion of international liquidity, the transfer of reserves would have been unsupportable and would certainly have triggered competitive devaluations as well as restrictions on trade and international payments. In view of a potential reaction of this nature, the only acceptable option was to create international liquidity by official mechanisms and by operations of the private capital markets. The international community had more than one formula for raising global reserves. It could issue SDRs and increase the value of gold holdings by modifying the official price, or it could use the alternative of providing temporary liquidity through mechanisms for financing balance of payments available in the IMF. Unfortunately, this potential supply of basic liquidity bore no relation to the specific needs of the countries. If this supply had become reality, the advanced countries would have been the principal beneficiaries, particularly those without serious balance-ofpayment problems. Nor was it easy to achieve the indispensable consensus to set up the mechanisms to create temporary reserves, among other reasons, because of some countries’ objection to increasing world liquidity for fear of consolidating the oil price rise and fueling the inflationary process that the world had been experiencing for several years. Issues of SDRs had been frozen since 1972 at the end of the first basic period, which had begun in 1969. During the following 5 years, there was no minimum consensus for a new allocation despite substantial expansion of international trade and growing external imbalances during the first half of the 1970s. The reasons for underestimating these factors had to do with the adoption of floating exchange rates and the effective revaluation of gold holdings, associated with the price increase on the private gold market and, above all, with a massive increase in financing from the international capital markets. Although these considerations did not apply to the majority of developing countries, they were sufficient to prevent a new issue of SDRs. All the same, if a new issue of SDRs had been made, it would not have resolved the reserve requirements of the developing countries since the rules of allocation were based on IMF member quotas, which favored the developed nations. The modification of the distribution scheme through linking SDR issues with development needs never prospered, nor did the efforts to place the SDRs at the center of the international monetary system. There was apprehension that the growing supply of SDRs

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would erode the predominant position of the dollar as a reserve currency and weaken the fight against inflation; some supposed that increasing the SDR supply would relax the discipline imposed by the accumulation of reserves. Years later, in 1978, a consensus was finally reached on a new issue of four billion SDRs for the 1979–1980 period. This came too late to relieve the oil imbalance and was insignificant in relation to total holdings of reserves, which were in the region of 230 billion SDRs at that time. Similar considerations applied to the formula for raising the official gold price, which was very much below the current market price—with the great difference that, in practice, this asset had become immobilized because of the gap between the official and market prices. About 24 percent of total international gold reserves were frozen, creating a severe restriction on the availability of funds for dealing with balance-of-payment problems for both member countries and the IMF because the reserves could only be used in transactions at the official price. The IMF held 150 million ounces or 15 percent of total gold reserves. At the end of 1973, the price was still at 35 SDRs per ounce, the level before the last devaluation and equivalent to a quarter of its market value. The metal had been frozen since the declaration of the inconvertibility of the dollar in August 1971 because of (1) the ban on trading at a price other than the gold content of the SDR and (2) the option of selling on the private market bringing with it the risk of precipitating a fall in prices. Moreover, the lack of definition of the role of this asset in the reformed monetary system led to great caution in its use, even with respect to IMF holdings, although maintaining the fiction of the official price was becoming increasingly unacceptable. The solution to the gold problem was not easy but could not be left until the comprehensive reform of the international monetary system. Any solution had to include an increase in the official price to a level close to market price. Such a change would return gold to its former position as the principal reserve asset in the early years of the Bretton Woods system. This would have set back one of the principal objectives of the reform, which was to convert the SDR into the central asset and reduce the presence of gold and currency reserves. In fact the revaluation of gold would have satisfied global liquidity requirements until the present day, according to estimates at the time. The privileged position of the dollar would have been toppled and the SDR buried. A temporary way out of this dilemma was to permit partial mobilization of gold by authorizing its use to guarantee balance-of-payment loans, which were a means of increasing liquidity, although only temporarily. In fact only Italy used this facility. The other solution came at the end of 1974, when it was recommended that countries value their gold reserves at market price—once again of little use. A lasting solution had to wait until the implementation of the reform that demonetized gold, transforming it into a normal primary product with unrestricted market trading.

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In the context of balance-of-payment problems, another measure to mobilize gold proposed by the United States was to sell part of the IMF holdings and use the receipts to finance the balance of payments of developing countries. The initiative increased the availability of low-cost funds and contributed to the objective of removing gold from its central position in the monetary system. This proposal complemented another U.S. proposal for the creation of an oil security net exclusively for the industrialized countries. This last idea never prospered, while the first crystallized into the establishment of the trust fund (1975) funded by the sale of onefifth of the IMF gold reserves, as well as the return of an equal amount to member countries at the official price. A portion of the gains obtained was returned to the fund as contributions from the OPEC Fund. Recycling the Petrodollars

The expansion of international liquidity through increases in the basic reserves of the system—SDRs and gold—was of negligible significance in relation to requirements. The system had to respond by creating temporary reserves from loans from official organizations and international banks, in both cases financed with the funds accumulated by the countries with balance-of-payment surpluses, particularly funds concentrated in the oil-exporting countries. The circulation of external income, or recycling, as the process was known, was quite extraordinary because it involved large amounts from creditor countries very different from the traditional ones. The financial system had never before had to deal with the recycling of such unusual funds, and there was uncertainty about the system’s capacity to respond adequately to this singular task. The difficulties predicted for the recycling of the liquid assets of the oil countries—petrodollars—involved in one form or another the capacity of the private institutions to offer intermediation at the level of the atypical global imbalance. For example, the solvency and liquidity of the banks in the Euromarket, where most of the liquid funds of the OPEC members were placed, seemed inappropriate for the required operations. This impression was due to the recent collapse of some banks and to the large exchange losses suffered by others, which had exposed capital weaknesses and deterioration in recent years. Analyses at the time clearly noted the extent to which capital had declined in comparison with the volume of transactions and the inadequacy of the banks’ responses, which generally consisted of the establishment of subsidiaries in the Euromarket. Although this facilitated higher volumes of capital for foreign operations, it made no contribution to strengthening the consolidated position of the banks. The capital inadequacy was accompanied by deterioration in the quality of bank assets because loans were increasingly used to finance balance

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of payments, an area in which the banks had little expertise. In those years international banks had little or no experience in the evaluation of the risks of sovereign loans, whose servicing depended on macroeconomic and development policies. These loans could not be valued by the techniques applied to traditional commercial credit operations and loans for specific projects. The situation was no better on the liability side because of the high participation in deposits by a small group of countries that was very dependent on a single productive activity. Naturally, all these risks directed financing toward the countries with good credit ratings and to placement of oil funds with the largest banks, resulting in a concentration of financial intermediation. The problem of liquidity was transitory and structural—transitory because of distortions in the yield curve that generated much higher shortterm rather than long-term interest rates, thus discouraging intermediation. The distortion in rates was due to fears created by the collapse of two banks (Herstatt and Franklin National); the distortion was reflected in interbank activities, generating a shortage of lendable funds and a steep rise in their cost. All this strengthened the initial preference of the oil countries for liquid deposits and hampered the transformation of short-term funds into longer-term assets, in turn creating a sensation of scarce liquidity, when the reality was quite the opposite. Fortunately, the distortion was short-lived. The speedy recovery of confidence in institutional stability and the fall in U.S. interest rates rapidly eliminated the distortion in rates and reversed the decline in intermediation. Similarly, doubts about the structural capacity of the Euromarket to sustain a strong expansion were ephemeral: the credit operations rarely produced a multiplier effect on deposits. Unlike what had occurred in domestic markets, most of the real transactions took place outside the Euromarket, with only a fraction of each dollar lent returning to the market. In fact, these leaks declined with the circulation of petrodollars and later with the integration of international capital markets and the preponderance of purely financial transactions, with no direct relation to real flows of goods and services. The other alternative for the circulation of oil funds was the domestic markets of the advanced countries, especially the United States. The latter offered more security and depth than the Euromarket, but at the price of sacrificing returns and anonymity, which were important considerations for some OPEC members. These factors discouraged the supply of oil funds, while demand was also depressed by regulations (in particular the limitation of loans to a proportion of the capital and reserves of the banks) according to the type and risk of the assets. In international credit operations, the rules hindered recycling because the key factor in risk weighting was a country’s capacity to generate foreign exchange, which was precisely

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the weakness of several oil-importing countries. Other important national markets suffered from similar handicaps, which were aggravated by the exchange risk factor because the bulk of oil receipts were in dollars. In the end, the flexibility of the Euromarket imposed itself on the recycling process. It had a special aptitude for harmonizing the asset preferences of the creditor countries with the needs of the debtor countries. This market offered efficient options of exchange transformation, giving it a privileged position in reconciling the combination of currencies required by its depositors and borrowers. It was aided in this by appropriate interest elasticity and a forward exchange market to cover positions in different currencies. There was no better intermediary than the Euromarket for operations between countries. It was a channel with no legal barriers on capital flows and capable of amalgamating funds from different sources and placing them in any corner of the world. The advantages offered by the Euromarket led to its involvement for the first time in country loans. It was transformed into the principal channel for the circulation of petrodollars and was preferred by the United States because its operations were based on a private market. Little scope was left for official action, which was restricted to complementing the market in case the latter did not respond adequately by ignoring the needs of the developing countries. Some countries were left out because their level of development denied them access to markets—as happened to more advanced countries because neither the costs nor the terms of finance had any relationship to their repayment potential. An additional complication was that the new floating interest rates exposed the former to adverse fluctuations, as in the early 1980s, which contributed to the foreign debt crisis. To cover the shortcomings of the private markets, the international community introduced new mechanisms of financial cooperation: some to support the industrialized countries and others to benefit all the countries with balance-of-payment difficulties. The European Economic Community, for example, introduced an arrangement to obtain a market loan of $3 billion, with a joint guarantee to assist members with balance-of-payment difficulties. Another initiative was the creation of a security net for OECD member states, but neither of these mechanisms ever functioned. The most complete formula for recycling was the oil facility established in the IMF that aimed to attract funds from the oil countries and transfer them to countries with limited access to other sources of finance. The funds for these operations came almost entirely from the OPEC countries through loans at near-market interest rates. This was an attractive solution for petrodollars and solved the problem of the shortage of liquidity in the IMF. The facility’s other original characteristic was the absence of conditionality, in line with its aim of reducing the need for adjustment— quite different from the IMF’s ordinary facilities. It was open to any net-oilimporting country with a balance-of-payment problem, but was expected to

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Two Crucial Problems

give priority to the needs of developing countries. For creditors, the facility offered greater security for savings and complete liquidity in case of an external deficit. The design of the oil facility was so well conceived that it could easily have become an important means of recycling, but its size was restricted to avoid competition with private markets and avoid contributing to maintaining oil prices; in fact, its contribution to recycling was very modest. Credits granted totaled only 6.9 billion SDRs (approximately $11 billion), including those supplied by the second oil facility, which was created 1 year later (1975). Even in this deformed state the facility gave important assistance to importing countries, mainly the most developed ones, which received about 63 percent of funds, about half going to Italy and the United Kingdom. The remainder of the funds went to developing countries, greatly assisting those without access to private markets. In parallel with this innovative scheme for assisting member states, the IMF improved the flexibility of compensatory finance and increased the amounts available in the conditional credit tranches from the traditional 25.0 to 37.5 percent of the quota. Both measures stimulated the use of these funds and increased total drawings that, excluding those related to the reserve tranche, rose to 4.6 billion SDRs in the critical years of 1974–1975, compared with 0.5 SDRs billion in the preceding 2 years, excluding the SDR allocation of almost three billion in 1972. From 1974 until 1978, the year before the second hike in oil prices, the IMF engaged in unprecedented financial activity, with disbursements totaling 19 billion SDRs. Even so, the contribution by official financing mechanisms to the oil imbalance was marginal, though of better quality than that offered by the private market. In any event, both sources supplied the requirements of international liquidity, which rose from $184 billion in 1973 to between $200 and $220 billion during the next 2 years. After the initial difficulties that arose following the rise in oil prices, recycling disappeared as an international problem. Appendix 4.1 to this chapter shows that the surplus of the oil-exporting countries plunged in 1975, and by the end of the next 3 years was insignificant. Much earlier, the surplus had ceased to cause tensions in the world financial system, and not even during the second price hike was there any need to establish mechanisms to recycle the additional revenue. As remarked earlier, the structural barriers to the adjustment of the economies of the oil-exporting countries were less serious than originally thought. Physical bottlenecks, such as ports and transport, were rapidly overcome, while domestic demand increased very rapidly—and before the end of the 1970s several countries had to seek external borrowing to maintain their development programs. According to IMF estimates, during the 1974–1978 period, OPEC countries spent about $500 billion on imports of goods and services or about 75 percent of their oil income. On the export

The Recycling of Petrodollars

95

side, measures to rationalize consumption in the importing countries and the appearance of alternative energy sources combined to reduce the volume of oil sales and erode real prices. OPEC lost the dominant position it had held in the 1970s some years ago, and the decline in oil sales has been such that at the end of the 20th century OPEC’s share of the world market has shrunk to 40 percent. Oil prices did increase slightly, but below international inflation that caused a fall of 25 percent in the terms of trade since 1978. This combination of factors swiftly reduced the first windfall surplus in the transactions of the oil countries and explains the lack of concern about the second oil shock in 1979–1980. Capacity for absorption had been amply demonstrated and the imbalances were insignificant in real terms relative to the size of the economies involved. Since 1974–1975 the circulation of oil export income has caused no difficulties, at least for most OPEC members. For the net-oil-importing countries, the transfer of real resources and the recycling of petrodollars functioned adequately, avoiding the risk of competitive devaluation and restrictions on payments and international trade. The deepening of the existing recession could not be prevented, but the world economy escaped a general depression of the kind it had suffered in the 1930s. For the larger OECD economies, GNP at constant prices fell 0.1 and 0.30 percent in 1974–1975, compared with growth of 6.1 percent in the preceding 2-year period. The LDCs managed the situation better than before. Their growth was only slightly lower than the average annual rate of 6 percent in the preceding 5-year period. In both cases, recovery was swift and stimulated by growth in the industrialized nations, which in 1976 returned to the rate of expansion of the decade before the oil crisis, 5.5 percent annual average. The deficit on balance of payments of the industrialized countries fell sharply, ending 1975 at about $5 billion, due to the strengthening of the position of the United States, whose positive balance was almost $10 billion. The deficit of the nonoil developing countries, however, grew to $45 billion, although it fell rapidly later, and in 1977 was in the same range as in the late 1960s in real terms and in comparison with world production. In general, the challenge of the sudden substantial increase in oil export income was dealt with successfully, with a larger adjustment than expected by consumers and hydrocarbon fuel producers, and with an adequate compensatory movement of funds through transfers of real resources and expansion of international liquidity. The process, however, had important effects, particularly on the international capital market, in which recycling of oil funds determined the unprecedented expansion of international banking operations. This process laid the basis for the integration of capital markets and the globalization of finance. According to data from the Bank for International Settlements, the assets representing international loans doubled between 1973 and 1976. By

96

Two Crucial Problems

the end of the 1980s the level of these assets was equivalent to 17 percent of the GNP of industrialized countries, compared with about 5 percent in the early 1970s. The sources of funds for these operations cannot be determined with certainty, but income from oil exports was probably significant, at least as an initial impulse to the growth of international intermediation, because a high proportion of payments for these exports, possibly half, was placed in the Euromarket. Apart from these figures, which are not totally reliable, the vitality of banking activities was a clear indicator of the abundance of lendable funds from balance-of-payment surpluses. Another result of the flow of funds was that, for the first time, banks entered the business of direct lending to countries and assumed a central role in the transformation of the petrodollars into loans for deficit countries. The banks, however, lacked expertise in these operations, which in the case of oil were basically similar to consumer credit and very different from lending for specific projects capable of generating funds to service the obligations. As already remarked, all this was stimulated by the inclination of certain industrialized countries to favor market solutions over official action. The outcome was that numerous developing countries in the most advanced segment found an easy solution to their financing problems, in some cases not even related to the increase in the cost of oil. In fact, in the 1974–1975 period about half the deficit of the net-oil-importing developing countries was covered by funds from the international markets, and the proportion continued to increase in the following years, reaching a peak in the early 1980s, just before the external debt crisis. The risk of excessive dependence on private markets for financing balance-of-payment deficits was not entirely ignored. At first this was because of the weaknesses of the Euromarket, and later because of signs that easy access to the market was breaking down the discipline of adjustment in the borrower countries. The managing director of the IMF at that time, Johannes Witteven, in a conference in 1976 on the IMF and the international banking community, explicitly stated that the growing intervention by private banks in the financing of balance-of-payment deficits “could foment a climate of relaxed borrowing by the deficit countries.” He also warned of the possibility of debt-servicing problems and of “the responsibility of the banks which, seen in hindsight, left little doubt that the credits had sometimes been granted in a market climate that was not in accord with the preservation of adequate standards.” Even the representatives of the oil-exporting countries—particularly Venezuela—insisted on the advantages of intermediation by multilateral development organizations and tried to set a precedent by making investment agreements with these institutions. Since then the IMF has modified its methods and emphasized adjustment, with the modifications required by the circumstances. This change was reflected in the establishment of the expanded facility, whose purpose was to provide medium-term finance to stimulate structural adjustment in developing economies.

The Recycling of Petrodollars

97

Efforts to promote the adjustment and reduce finance were only effective in countries without access to private markets, but failed in the more developed countries, particularly in Latin America. Of the latter, several attained record figures in the ratio of debt service to imports and national product and still continued borrowing because interest was low, sometimes even lower than external inflation. Heavily committed to these borrowers, the international banks continued to meet the countries’ borrowing requirements until the outbreak of the debt crisis in 1982 sparked by a sudden increase in interest rates, which was in turn the result of excessive emphasis on monetary policy as an instrument for combating world inflation. Final Considerations

In the quarter-century since the first oil crisis, income from hydrocarbon fuel exports has never again created difficulties for the international financial system. The 1973–1974 episode was unique because of the size of the redistribution of world income and the consequent tensions created in the international financial system. The experience was also notable because of the speed with which the world economy adapted to the high price of energy, demonstrating that the exporting and importing countries had an unsuspected capacity to assimilate changes in oil prices. Since then, and particularly in the aftermath of the next price jump (1979–1980), the tendency has been to let the oil market resolve its own imbalances. The market has responded by expanding sources of supply and slowing the expansion of demand, thus reducing the real price of oil. Adjustment has become the primary response to the circulation of oil revenue, relegating finance to a lower plane in the channeling of these funds. The intermediation of these funds is unlikely to be of interest to the world economy in the foreseeable future. The fundamental reason is that oil production is now very diversified and the OPEC group—now representing less than 40 percent of the market—has no large exporter with limitations on absorbing additional revenue. This is equally true of the nonOPEC producers, which include a diverse range of economies. If the need to recycle funds ever returns, there should be no problem accommodating it through the capital markets, which are now globally integrated and easily able to satisfy the preferences of debtors and creditors. The circulation of oil export income lost its exceptional characteristics some time ago. Oil income is now no different from the circulation of income from other goods and services traded internationally. Even so, the same cannot be said of the circulation of oil income within the economies of the principal exporting countries. In short, the abrupt jump in oil exports provoked distortions in economic structures that have still not been entirely overcome and that have contributed very little to the diversification of the production and export

98

Two Crucial Problems

apparatus. The oil countries are still exposed to the volatility of the prices of a nonrenewable natural resource and to a pattern of energy consumption and production. Worse still, in those countries abundant income led to excessive growth in the public sector and weakened the private sector: economic growth and stability came to depend to a large extent on public expenditure and finance. This is the origin of the extreme sensitivity of these economies to fluctuations in oil revenue and to the difficulties of maintaining a firm course in the development process. To prevent oil surpluses from worsening the structural deformations and cyclical instability, these countries usually tried to reduce the flow of these funds into the domestic economic circuit. They established institutional mechanisms to preserve a portion of them for future use. Yet most of these initiatives—if not all—were short-lived because of pressure from domestic needs and the erosion of real oil prices. Attempts are still being made to control the internal effect of oil income, largely to soften the impact of price fluctuations, but it cannot be said they have been successful. The most disturbing aspect is that the inability to manage oil revenue could have worse consequences in the future than in the past. More intense international competition and globalization in general could create more barriers to productive diversification, and even reverse it in extreme cases. An urgent response is needed to the oil countries’ traditional problem of promoting development in the midst of relatively abundant external resources. This has been and is a very singular challenge, totally unlike the situation in which there is a shortage of productive factors and the only remedy is to ensure their efficient allocation. The circulation of oil export income is of the utmost importance for the countries that depend on it, but it has ceased to be a concern for the global economy. Appendix 4.1

1973 1974 1975 1976 1977 1978 1979 1980 1981 1982

Developing Countries: External Balance (billions of U.S. dollars) Surplusa 6.1 69.6 36.5 39.5 28.8 5.0 65.8 109.8 54.5 2.4

Oil Exporters

Change in Reserves 4.4 38.2 9.6 9.9 11.5 –4.4 27.1 30.5 –12.5 –31.3

Source: IMF Occasional Paper 77 (March 1991). Note: a. Balance of goods, services, and private transfers.

Deficita

–9.5 –37.1 –45.3 –31.9 –28.2 –39.6 –58.6 –81.4 –104.8 –82.6

Oil Importers

Change in Reserves 12.8 4.3 2.1 15.6 14.1 20.1 13.2 8.7 5.8 –4.5

5 Lessons from the Recent Financial Crisis in Indonesia Anwar Nasution

The contagious twin crises (of currency and financial companies) in Thailand in March–June 1997 rapidly spread to other Asian countries, including Indonesia. To defend its external reserve position, Bank Indonesia, the central bank, on 14 August 1997 abandoned the exchange rate intervention band and moved to a floating exchange rate system. Since then the exchange rate and interest rates have been fluctuating wildly. Between June and December 1997, the external value of the rupiah (vis-à-vis the U.S. dollar) depreciated by over 50 percent, bank deposit and loan interest rates soared to over 30 percent per annum, and the Jakarta Stock Exchange plunged by about 50 percent. By the end of 1997, according to an analyst at Pentasena Securities, only 22 of 282 firms listed on the Jakarta Stock Exchange were operating with sufficient cash flow.1 At the same time, liquidity has been very tight and depositors have had to pay an expensive penalty for withdrawing time deposits before their maturity dates. Capital outflows continued to accelerate in spite of the IMF standby arrangements and the very high interest rates on Indonesian securities, a sharp depreciation of the external value of the rupiah, and financial indicators that pointed to long-term solvency. This was because of the absence of a clear-cut and detailed government program for facing the private-sector external debt. Investors feared an imminent default on short-term debt, especially dollar-denominated private-sector debt; bankruptcies of the already financially weak banks and their clients; and the possibility of explosive inflation in the short term. The closure of 16 financially distressed private banks in November 1997 precipitated a rush on banks and capital flight. Imports were restrained, as foreign banks became reluctant to accept Indonesian letters of credit. The fear of further currency depreciation put exchange rates and interest rates under more pressure. Government decisions to limit access to foreign borrowings and to shift publicsector deposits from (mainly state-owned) commercial banks to the central bank squeezed liquidity. With banks suddenly illiquid, the risks of default 99

100

Two Crucial Problems

by corporate borrowers and bankruptcies also increased. The fact that Bank Indonesia moved in mid-August 1997 to a floating exchange rate system suggests that it had limited external reserves to defend the exchange rate. The financial crisis occured in Indonesia during an unfortunate time. On the domestic front, the weather-related problems created by El Niño— drought and forest fires—continued until 1998. This continues to have seriously damaging effects on production in the forestry and agriculture sectors, thereby reducing their exports and raising food prices. The economic problem was compounded by political uncertainty because of the presidential election slated for March 1998. Pervasive lack of confidence in the government further drove capital flight and eroded the external value of the rupiah. On the regional front, economic difficulty and slow growth in Japan and Korea surely reduced those nations’ demand for Indonesia’s exports and drained capital inflows from those countries. This chapter reviews the present currency and banking crises in Indonesia, their causes and impacts. The rest of the chapter is divided into four sections. The next section examines the recent macroeconomic development prior to the crises. The following section discusses the banking crisis. Then comes a section that analyzes policy responses to cope with the capital inflows since the early 1990s and the present exchange rate crisis. Conclusions are in the last section. Macroeconomic Policy

The present currency crisis in Indonesia exemplifies the inconsistency between fiscal and monetary policies in an exchange rate system with an intervention band. Such a system had generated not only real appreciation of the exchange rate but also substantial bets when the intervention band was finally abandoned on 14 August 1997. Because the growing current account deficit could not be financed by running down external reserves, there were two policy options available for the government to narrow or close the deficit: namely, to cut domestic absorption or depreciate the domestic currency. The authorities opted to defend its external reserves by moving from the intervention band system to a free float, which raised both interest rates and exchange rates. Because the banks have high bad loan ratios, the rising interest rate and exchange rate risks are likely to generate many bankruptcies, badly hurting the financial system and economic growth, particularly because of heavy reliance by Indonesian companies on debt financing. Indonesia was indeed in need of adjustment, particularly because of the weaknesses in its economic fundamentals2 and changes in international environment that began in 1995. On the domestic front, the massive capital inflows and the change in composition toward short-term private-sector

The Recent Financial Crisis in Indonesia

101

capital since the early 1990s had caused bouts of domestic economic overheating since the rapid economic growth was accompanied by a rising domestic inflation and interest rates and widening current-account deficit (Table 5.1). On the external front, a combination of the yen depreciation vis-à-vis the U.S. dollar since 1995 and a continuing weak banking system in Japan had slowed the inflow of Japanese foreign direct investment to Indonesia. Capital flows from newly industrializing economies (NIEs) also dried up due to slow growth of their exports and strains in their financial systems and companies (in the case of Korea). The rise in interest rates and investment returns in the United States further reduced capital inflows because they made investment in emerging countries, including Indonesia, less attractive. The combination of these internal and external factors began an interruption and reversal of foreign capital inflows. Exchange Rate Movements

The exchange rate is the single most important relative price in the economy. In a more open economy, monetary transmission operates through exchange rate effects on net exports and interest rate effects on financial portfolio. The exchange rate policy in Indonesia,3 along with other policies, traditionally had been used mainly to remove distortions in the domestic economy and help safeguard international competitiveness. Until recently, the authorities avoided the use of prolonged nominal and real exchange rate overvaluation as a principal instrument for generating fiscal revenues and curbing domestic inflation and interest rates. To offset the “Dutch disease” effect of the oil boom, in November 1978 the authorities devalued the rupiah by 50 percent against the dollar, replaced the dollar as its external anchor with an undisclosed basket of major currencies, and moved to a managed floating exchange rate system. The weight of the dollar in the currency basket remains substantial. The rupiah was further devalued by 40 percent in June 1983 and again by 31 percent in September 1986. In normal cases, the authorities’ target nominal depreciation of the rupiah against the dollar would be between 3 and 5 percent per annum. Bank Indonesia would intervene in the foreign exchange market by buying and selling the rupiah in an “intervention band” around the central rate. Provided that the system was supported by other policies, such an active policy to stabilize the real exchange rate would also help to avoid major macroeconomic crises, even when the world economic environment proved inhospitable. To allow market forces a greater role in setting the exchange rate, Bank Indonesia widened the intervention band six times since 1992 to 12 percent, effective from July 1997. In theory, this greater exchange rate flexibility should have introduced uncertainty that may well have discouraged part of

102

Two Crucial Problems

Table 5.1 Indonesia: Selected Key Indicators, 1990–1996 (as percentage of GDP, unless otherwise indicated) Internal Stability Gross Domestic Product Real GDP (% of growth rate) Agriculture Industry Services Consumption Private Government National Saving Private Public Investment Private Public Inflation (CPI) Fiscal Balance

External Stability Current-Account Balance

Net Capital Inflows Of which: Net Portfolio Investment Net Direct Investment Other Capital Net Error and Omissions Reserves (in months of imports) Ratio M2 to Reserves (%)

Total External Debt (in % of exports of goods and services) Short-term Debt (in % of total external debt) Short-term Debt (in U.S. $ billion)

Debt-Service Ratio (in % of exports of goods and services)

Exports (% of GDP) Exports (% of growth rate) Oil Price (U.S. $ per barrel)

1990

1991

1992

1993

1994

1995

1996

9.0 2.3 13.2 7.6 63.3 54.4 9.0 27.5 19.1 8.4 30.1 23.5 6.6 9.5 0.4

8.9 2.9 11.8 9.3 64.1 55.0 9.1 26.9 19.8 7.1 29.9 21.7 7.7 9.5 0.4

7.2 6.3 8.2 6.8 61.8 52.3 9.5 26.9 20.5 6.4 29.0 20.9 7.8 4.9 –0.4

7.3 1.7 9.8 7.5 64.7 55.7 9.0 27.0 20.4 6.6 28.3 20.9 7.4 9.8 –0.6

7.5 0.6 11.1 7.2 65.6 57.4 8.1 28.4 22.0 6.4 30.3 24.0 6.3 9.2 0.1

8.1 4.2 10.2 7.9 65.9 57.8 8.1 28.0 22.4 5.6 31.3 25.8 5.5 8.6 0.8

7.8 1.9 10.4 7.6 66.0 58.3 7.7 28.5 22.8 5.7 32.1 26.9 5.3 6.5 0.2

–2.8

–3.7

–2.2

–1.6

–1.7

–3.7

–4.0

–0.1 1.0 3.3 0.7

0.0 1.3 3.6 0.1

–0.1 1.4 3.5 –1.0

1.1 1.3 1.4 –1.9

2.2 1.2 –0.9 –0.1

2.0 2.2 1.3 –0.9

n.a. n.a. n.a. n.a.

4.9

5.0

3.8

1.9

2.4

4.6

5.0

4.7 514.0

4.8 505.7

5.0 497.4

5.2 557.1

5.0 602.9

4.4 657.4

5.1 633.3

222.0

236.9

221.8

211.9

195.8

205.0

194.0

11.1

14.3

18.1

18.0

17.1

24.3

29.3

30.9

32.0

31.6

33.8

30.0

33.7

33.0

15.9

26.6 15.9 28.64

17.9

27.4 13.5 20.06

20.5

29.4 16.6 18.71

20.1

25.9 8.4 14.14

17.7

26.0 8.8 16.11

20.9

26.0 13.4 18.02

24.8

26.2 9.7 22.78

Sources: IMF, International Financial Statistics, various issues; IMF, World Economic Outlook, various issues; J.P. Morgan, World Financial Markets, Indonesia, 27 June 1997, 69; J.P. Morgan, Emerging Market Data Watch, ASEAN Currency Risk After the Baht’s Fall, 7 July 1997, 3–4.

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103

the purely speculative capital flows and allowed a higher degree of freedom for the monetary authorities to exercise control over monetary aggregates. Since it allows a slight temporary appreciation of the rupiah, the policy should also have reduced the need for sterilization of the surge in capital inflows. The adjusting factors of such active management of exchange rate policy have been rising domestic inflation rates and interest rates. The pressures for rising inflation rates have been partly suppressed by the government’s policy of running “budget surpluses” or narrowing the budget deficit, the policy to subsidize prices of state-sold products,4 and adopting a more vigorous trade liberalization program. Trade policy reform and productivity gains generated by the economy-wide reform helped relax the supply constraint and check the inflationary pressures. With regard to interest rates, until recently, the authorities had imposed a complicated system of credit ceilings and directly controlled allocation of banks’ credit, as well as deposit and lending rates. The selective credit policy helped support allocation of resources as set by the authorities, including to projects favored by the remaining import substitution industrializing (ISI) policy and the executing firms. A steady appreciation of the rupiah between 1990 and 1996 indicated a slight change in government policy with respect to the exchange rate. The rupiah appreciation was also due to the rising value of its main external anchor, the dollar in relation to the yen. The rupiah appreciation helped reduce inflation and interest rates in 1996. However, the appreciation eroded the external competitiveness of the economy, distorted saving and investment decisions, and squandered the scarce savings on unproductive investment projects, thus impeding the efficiency of the economy at microeconomic level. The decline in inflation rates, however, helped to stabilize the rupiah appreciation. Widening Current-Account Deficit

Having been maintained at below 2 percent of annual GDP in 1993 and 1994, the current-account deficit rose to 3.7 percent in 1995 and 4.0 percent in 1996. This deterioration did not only reflect higher investment. Table 5.1 shows that the widening current-account deficit between 1993 and 1996 was the result of an increase in overall investment—from 28.4 to 32.1 percent of GDP. One of the links in this occurrence was the banking system, which converted part of the increased liquidity into loans to finance investment, including those in land-based industry (hotel and tourist resorts, amusement and industrial parks, real estate, commercial buildings, and shopping malls), excessive infrastructure, and other nontradables. Most of the private debt was directly borrowed from foreign lenders, and only a small fraction of it was intermediated through the banking system.

104

Two Crucial Problems

Part of the capital inflows was probably used for financing consumption expenditure. This is partly shown by a slight decline in savings rate in the national account data. In addition, there was a rapid increase in the number of credit cards issued and in the volume of transactions. In fiscal year 1996/97, ending in March, the number of credit cards amounted to 1.6 million, having grown by nearly 30 percent as compared with 28 percent in the preceding year. In the same year, the value of transactions using credit cards amounted to 4.7 trillion rupiahs, or a growth of over 35 percent as compared with 22 percent in the previous year. As of this writing, there are 17 banks and 84 finance companies (operating with 40,000 merchant outlets throughout the country) licensed for credit card trans actions. The widening external deficit did partly reflect irresponsible fiscal behavior. A combination of greater tax collection effort, tightening of fiscal policy, and improvement in the operations of state-owned enterprises reduced government budget deficits and increased public-sector savings. While formally maintaining the “balanced budget principle,” in reality the government ran an annual budget surplus of 0.2 to 0.8 percent of GDP since fiscal year 1993/94.5 Evidence suggests that the Ricardian equivalence issue—which points to the possibility that the increase in public savings will be offset by a decline in private savings—has been relatively limited in the ASEAN region, including Indonesia. 6 The increase in public savings immediately raised national savings and thus helped reduce inflation and interest rates and the current deficit. Also lower interest rate differential slowed capital inflow. As a result, the widening of the tax base, removal of egregious marginal tax rates, and significant improvements in the efficiency of tax administration and operations of the public companies made an important contribution to enhancing fiscal flexibility and helped stabilize domestic aggregate demand and improve external competitiveness. The budget “surplus,” however, was inadequate to counter the rapid expansion of “off-budget expenditures” and government-sponsored projects. There is no information on the off-budget expenditures, but the list of projects financed by it had rapidly expanded, including the aircraft and national car industries. 7 Capital inflows in such highly protected sectors generate welfare losses because, aside from producing negative value added at international prices, they also remove resources in the form of repatriated profits from the country. The fiscal position will be more difficult in the future because of the revenue losses that stemmed from the introduction of tax incentives for the national car program (and other pioneer proj ects) and the tax-deductibility of individual contributions to such poverty alleviation initiatives as Takesra, headed by the president of Indonesia.

Stock of External Debt

The Recent Financial Crisis in Indonesia

105

The levels of Indonesia’s external debt were alarming by world standards. The debt service ratio ranged from 30 to 34 percent between 1990 and 1996. Mainly because of the surge in private-sector borrowings, the stock of external debt of Indonesia rapidly increased from $66.9 billion in 1990 to $131.4 billion, around 200 percent of export value or about two-thirds of GDP in 1997. Of this amount, about half was public medium- and longterm debt, and about $66 billion was in short-term loans. Most of the short-term external debt ($49.3 billion) was borrowed from foreign banks, of which there was $29.6 billion with a maturity of 1 year and $19.7 billion with a maturity of 1 year.8 The average maturity of this external debt was approximately 1.5 years. In addition, short-term external debt denominated in local currency amounted to $15 billion. Interest payments amounted to 12 percent of total exports. Over two-thirds of the bank loans ($32.6 billion) were received by the nonfinancial private sector, around 39 percent ($19.1 billion) by the central bank for building up its foreign reserves, $10.1 billion by the financial sector, and $6.5 billion by the public sector. Most of the private sector’s external borrowings, however, were explicitly and implicitly guaranteed by the state. These included foreign borrowing for financing economic infrastructure projects, owned mainly by politically well-connected groups. The Banking Crisis

In terms of total assets and number of offices, the banking system is the core of the financial sector in Indonesia.9 The reform in the banking system started in June 1983 by liberalizing interest rates and the complicated ceiling-cum-selective credit policy with subsidized interest rates. Other elements of financial repression were removed with the market liberalization introduced after October 1988. The reform ended the financial market segmentation and improved market competition. However, the system was simply bankrupt because the capital base of the commercial banks was relatively inadequate to cover the high proportion of bad loans, which were partly inherited from the long period of financial repression. The bad debts increased further after the banking reform, among others, because of the weakness in the implementation of the new prudential rules and regulations.

Surges in Capital Inflows and the Lending Boom

The banking reforms caused excessive credit expansion by the banking system. On average, the outstanding credit of commercial banks increased

106

Two Crucial Problems

by 24.3 percent per annum between 1992 and 1996 (Table 5.2). A combination of lifting restrictions on bank lending and regulations on asset portfolios, lowering of reserve requirements, market opening, privatization, and greater access to offshore markets encouraged rapid rates of credit expansion. The presence of new entrants in a more competitive market environment may well have increased the pressures on banks to engage in riskier activities. Yet bank credit officers reared in the earlier controlled environment may not have had the expertise needed to evaluate new sources of credit and market risk. When an economy is booming it is difficult to distinguish between good and bad credit risks because most borrowers look profitable and liquid. Lifting restrictions on bank lending immediately expanded credit to the land-based industries and excessive infrastructure projects. Part of this credit expansion was financed by foreign borrowings. In addition, the surge in private capital inflows relative to the size of the equity market drove up equity prices. The financial-sector reform relaxed standards for domestic banks in their foreign exchange transactions and in opening branch offices overseas. It also allowed greater penetration by foreign banks into the domestic economy and larger ownership by foreign investors of domestic assets. Moreover, the new rules and regulations replaced the administrative ceilings on offshore borrowings by commercial banks with a more rational system of net open positions. Along with privatization, the authorities abolished the limits for inflows of foreign direct investment (FDI) and foreign ownership of equities issued in domestic stock markets. Prior to the recent reform, Indonesia in 1971 had adopted a relatively open capital account and managed unitary exchange rate.10 Under this system there was no surrender requirement for export proceeds or taxes or subsidies on the purchase or sale of foreign exchange. Indonesian citizens and foreign residents were free to open accounts either in rupiahs or in foreign currencies at the authorized banks (“bank devisas”), which were authorized to extend credit in foreign currency in the domestic market. To encourage internal foreign investment, between January 1979 and December 1991 a special effective exchange rate was made available to domestic borrowers by providing an explicit subsidy on the exchange rate. The subsidy was extended through the exchange rate swap facility, under which Bank Indonesia provided forward cover to foreign-exchange-borrowing contract swaps to banks and non-banking financial institutions (NBFI) and to customers with a foreign currency liability. The subsidy came about because of the time lag in either an upward adjustment of the swap premium or a nominal depreciation of the rupiah, or a combination of both. Herd behavior by foreign investors also had a role to play in increasing capital inflows and outflows to and from Indonesia. The investors did buy stock, commercial papers, and even real estate, and invested excessively in infrastructure projects. Peregrine, a Hong Kong–based investment

17.3 12.2 3.5 100.0 21.0 21.0 0.0

54.2 35.2 88.1 98.3 41.7

15.9 44.6

23,819 60,811 1,074 20,852

10,659 95,898 –12,024 7,709 100,214

1990

20.2 15.6 3.6 71.6 23.4 25.2 1.8

16.3 11.8 19.6 37.8 13.6

12.1 17.5

26,693 72,717 990 30,885

17,283 114,002 –12,711 9,706 117,007

1991

19.1 17.9 6.9 88.0 19.5 24.1 4.5

8.9 14.0 1.2 9.6 15.3

7.9 21.1

28,801 91,570 1,752 38,767

29,544 130,030 –6,547 6,019 130,558

1992

17.5 18.8 13.6 94.4 14.5 20.5 6.0

22.3 4.8 42.8 57.9 17.9

27.8 21.5

36,805 109,402 2,233 40,516

28,489 157,396 –11,848 6,505 162,739

1993

17.5 19.1 9.3 79.7 12.6 17.8 5.1

25.7 11.8 42.8 24.7 18.2

23.3 20.1

45,374 130,280 2,038 44,071

24,390 193,458 –14,292 6,874 200,876

1994

Sources: Bank Indonesia, Indonesian Financial Statistics, various issues; IMF, International Financial Statistics, various issues.

Memorandum Items: 1. Dollar deposits at DMB % of M2 2. Credit in dollars as % of total credit 3. % of total excess liquidity of DMBs held in U.S. $ 4. The role of SBI in total market instrument (%) 5. Deposit rates (3-month, % per annum) 6. Lending rates (working capital, % per annum) 7. Interest rates differential (6–5) (%)

Rate of Growth Bank Credit (% per year) State Foreign Exchange Banks Private National Banks Foreign and Joint Venture Banks Regional Development Banks

Rate of Growth Money Supply (% per year) M1 (narrow money) M2 (broad money)

Assets Foreign Assets (net) Domestic Credit Claims on Government (net) Claims on Official Entities Claims on Private Sector Liabilities Money Quasi-Money Import Deposits Other Items (net)

Table 5.2 Monetary Survey (in billions of rupiahs)

17.4 19/5 6.8 73.8 16.8 18.9 2.1

24.2 16.8 29.4 32.0 24.8

16.1 27.5

52,677 171,257 2,240 44,985

30,258 235,356 –19,235 8,427 246,164

1995

17.2 20.2 2.7 78.7 17.2 19.2 2.0

24.9 16.5 34.3 13.8 23.2

21.7 29.6

64,089 226,097 2,535 59,416

50,912 288,788 –20,922 9,246 300,462

1996

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Two Crucial Problems

bank, collapsed in early January 1998 due to a single massive bad loan ($265 million) to PT Steady Safe, a local taxi company in Jakarta. Steady Safe used $145 million to buy 14 percent of a toll road building company owned by Ms. Siti Hardiyati Rukmana (“Tutut”), the eldest daughter of President Suharto. She was then named to Steady Safe’s board.11 The reform, which covered nearly all aspects of the economy, combined with the perception of Indonesia as a stable country and one of Asia’s success stories,12 generated a massive capital inflow after the early 1990s. Demand for securities issued by Indonesian (state- and privateowned) companies increased since foreigners had been allowed to own up to 49 percent of the listed shares issued by national companies (except banks). The national companies were also allowed to raise funds by selling securities in domestic and international stock and bond markets. The amount of capital inflows increased by almost two and half times since 1990, reaching the level of $14.7 billion in 1994. Increasing Bank Liabilities with Large Maturity/Currency Mismatches

A combination of liberal capital account, financial-sector reform, advances in technology, and information processing have made it easier for Indonesians to alter the currency composition of their deposits. The high ratios of broad money (M2) to GDP, dollar deposits as a percentage of M2, the credit in dollars as a percentage of total credit, and the excess liquidity of commercial banks held in dollars (Tables 5.1 and 5.2) indicate the high percentage of debt instruments in Indonesia denominated in foreign currency, particularly the U.S. dollar. As emphasized by Calvo13 and Mishkin14 this makes it more difficult to manage both the banks’ portfolios and the macroeconomy. Pursuing an expansionary policy, for example, is likely to cause a devaluation of the rupiah and a rise in the inflation rate. Traditionally, Indonesian banking and bank customers borrow short and lend long and maintain a high debt-equity ratio. When domestic interest rates are high, there is a strong temptation for them to denominate debt in foreign currency. Bank devisas turn to short-term, foreign-currency-denominated borrowing in the interbank market to fund longer-term bank loans. External borrowings by the financial sector in Indonesia rose from $6.0 billion in 1993 to $12.1 billion in 1995, and fell to $11.0 billion in 1996 and to 10.1 billion in mid-1997.15 Between December 1996 and December 1997, the rupiah sharply declined from 2.383 to 5.652 to the dollar, and the foreign-currency-denominated liabilities of commercial banks operating in Indonesia increased from 27 trillion to 55 trillion rupiahs. Partly because of a historically predictable trend and low rate of the rupiah depreciation, a large portion of the external debt is unhedged. This not only makes banks and their customers more vulnerable but also makes

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it harder to deal with the banking crisis, the rise in interest rates, and the sharp devaluation of the rupiah. Sharp depreciation of the rupiah deteriorates banks’ and firms’ balance sheets because much of their debt is denominated in foreign currencies. The substantial falls in the external value of the rupiah to the dollar rapidly raises the cost of renewing or rolling over the short-term floating-rate dollar or yen loans in real terms. The indebtedness of Indonesian banks and firms rises and their net worth falls. The rise in interest rates causes interest payments to rise, resulting in a deterioration in the balance sheets of the banks and their customers. The risks of maturity mismatches are higher for the unlisted banks, which have no access to mobilize long-term sources of funding (by selling bonds, shares, and other types of securities) in stock markets. Selling equity in stock markets can also mean spreading or sharing the risks. The risks are higher because most companies in Indonesia rely exclusively on bank loans for financing, with land as the main collateral. Only a handful of companies supplement bank financing with equity offerings. The high loan-to-value ratio of bank loans to such companies as property developers exposes the Indonesian banks to sharp declines in real estate prices. This and the plunge in equity prices depressed the market value of collateral and assets of the banks. The liquidity problem became more difficult because there was no securitization of mortgages and no market for government bonds. Weak Financial Positions of Banks and Highly Concentrated Problem Loans

Liberalization of the banking industry will surely produce long-term benefits for Indonesia. In the short run, however, deregulation inevitably presented banks with new risks that, without proper precautions, led to the current banking crisis. Despite a relatively high economic growth of 6 percent plus per annum since 1990, the problem of bad loans in the national banks appears not to have diminished significantly. As shown in Table 5.3, the problems are likely to be more severe at state-owned bank group and non-foreign-exchange banks. The state bank group was the main provider of credit programs, with subsidized interest rates, during the long-past era of financial repression. This group of banks was also the main victim of erratic government policies, such as shifting public deposits to the central bank. As of November 1996, the bad debt of the total banking system amounted to 10.4 trillion rupiahs (equivalent to about 2 percent of GDP or around 10 percent of total loans), and 7 trillion rupiahs (68 percent) of this was held by state-owned banks. PT Bapindo, one of the seven state banks, is technically insolvent because the amount of its bad loans is much greater than its capital. Close to 12 percent in 1995, the actual average of the risk-based capital ratio of all commercial banks in Indonesia was higher than the Basel

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minimum standard of 8 percent. Nevertheless, according to the World Bank,16 there were 22 banks (out of the total of 240 banks in mid-1995) that did not meet the capital adequacy ratio, and 65 banks did not meet the legal lending limits regulations. The latter restrict the aggregate amount of loans and advances to insiders, a single borrower (person or firm), or to a group of borrowers.17 Traditionally, state-owned banks were undercapitalized. The low capital requirements of the past were hardly enforced for this group of banks because of the presumption that the state would stand by its banks and that the insolvency of state-owned banks would be carried over to the fiscal balance. Overstaffing and overextension of branch networks were also more prevalent for the state-owned banks. Because these banks were constitutionally protected from closure and had their losses covered by the public budget, they tended to have fewer incentives to innovate and promptly identify problem loans early and to control costs. Because the risks of the state-owned banks are assumed by the state, the lending skills (including risk appraisal) of the officers of these banks were generally weak: their Table 5.3 Commercial Banks’ Classified Credits, 1993–1997 (as percentage of total credit) Total credit (trillions of rupiahs) Substandard Doubtful Bad-debt

Distribution of bad loans by bank ownership (as percentage of total bad loans) State-owned banks Private banks Provincial development bank Foreign and joint-venture banks

Bad loans as a percentage of total credit by group of bank ownership All banks State-owned banksa Private foreign exchange banks Private non-foreign-exchange banks

1995

267 2.7 2.4 3.3 72.7 16.3 5.5 5.5

1996

331 2.6 3.3 2.9

April 1997 350 2.8 3.5 2.3

67.0 22.8 4.9 5.3

65.9 24.5 4.8 4.8

10.4 16.6 3.7 13.8

8.8 13.4 4.3 1.1

Sources: Adapted from the World Bank, 1997, “Indonesia: Sustaining High Growth with Equity,” Report No. 16433–IND, 30 May, Box 5.10, p. 128; and Bulletin Info Financial, 39/VIII, 16 July 1997. Note: a. The decline of classified credit to 13.4 percent of total credit at state banks in 1996 was mainly due to the writeoff of the bad loans at Bank Rakyat Indonesia and Bank BNI in preparation for their privatization.

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loan loss performance was usually inferior to that of their private-bank counterparts. Heavy Government Involvement in the Selection of Credit Customers

Despite privatization, the six state-owned banks (Bank Bumi Daya, Bank BNI, Bank Exim, Bank Rakyat Indonesia, Bapindo, and Bank Tabungan Negara) still retained significant (over 30 percent) bank assets in Indonesia. This figure would be even higher if computed under a broad definition of indirect ownership: Bank Indonesia, state-owned banks, line ministries, and various branches of the armed forces also own banks. The banking system with its relatively high state ownership is affected by a greater intrusion of government political objectives in almost all aspects of bank operations, including personnel and technology policies. Accordingly, such a banking system also has greater recourse to the public financing for bank bailouts. For decades, loan decisions by state-owned banks were subject to explicit or implicit government direction. All too often, the creditworthiness of the borrowers did not receive sufficient weight in credit decisions, with the result that loans by state banks were vehicles for extending government assistance to particular industries and a handful of politically wellconnected business groups (these groups—the conglomerates—control a large proportion of Indonesia’s GDP and a vast range of mostly rent-seeking activities). Deregulation has not ended government intervention in the lending decisions made by state-owned banks and financial companies, shown, for instance, by government intervention in providing credit to Mr. Edi Tansil and to PT Timor Putra Nusantara, which was done after the banking reform and, allegedly, by those who promoted the reform.

Bad Governance

Along with the market liberalization, the financial-sector reform also adopted in February 1991 a more restrictive CAMEL (capital adequacy, asset quality, management, earning, and liquidity) system to regulate and supervise banks. Indonesia also adopted a set of rules and regulations on legal lending limits to limit loans extended to bank insiders (owners or managers and their related businesses). The implementation of the prudential rules and regulations were and are, however, very weak. This is partly because of structural weaknesses in the legal and accounting systems. The regulators and bank managers did not have sufficient personnel to supervise and examine the quickly growing number and expanding powers of the financial institutions. In an autocratic system like Indonesia’s there is a principal-agent problem because regulators may not operate

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Two Crucial Problems

in the principal’s interest. The cases of commercial papers issued by PT Bank Pacific, PT Bank Arta Prima, and PT Bank Perniagaan even indicate fraud and collusion with the bank supervisors at Bank Indonesia. Four bank supervisors at Bank Indonesia were arrested in early August 1997 allegedly for receiving bribes while making inspections during the 1993– 1996 period.18 As indicated earlier, official corruption may also involve the use of Bank Indonesia’s funds to buy shares of problem banks and provide low-cost and low-risk liquidity credit to troubled banks. Underregulated banks lead to excessive investment by the economy as a whole.19 Moreover, private banks often belong to business conglomerates and do not deal toughly with affiliate companies, particularly since the private banks can expect assistance from the central bank. And attaching loan collateral is a costly and time-consuming process that therefore reduces the effectiveness of collateral in resolving adverse loan collection.20 The Lender of Last Resort

At present, Indonesia has neither a deposit insurance scheme nor a bailout program to support domestic banks when they face bank runs. Bank Indonesia, however, provides support programs on an ad hoc and nontransparent basis. The support includes capital injections, liquidity credit, and emergency financial supports. To strengthen the primary (tier I) capital of commercial banks, Bank Indonesia acquires shares of problem banks and provides them with equity capital. The rapid growth of Bank Indonesia’s support to distressed banks is reflected by the rapid growth of claims by the monetary system on the private sector (Table 5.2); this includes claims by the central bank on commercial banks. A combination of weak market infrastructure, misfeasance, and malfeasance has allowed certain individuals to use their banks to swindle the general public of their deposits, to skim equity share and liquidity credit from the central bank and the public sector, and to issue fake commercial papers and obtain offshore borrowings (without proper backing) for financing questionable projects owned by these individuals. A typical balance sheet of this kind of bank is shown in Table 5.4. Loans by typical “swindle” banks are given mainly to nonbank companies owned by the principal owner(s) of the bank for financing investment projects, usually at inflated prices. The liabilities of such banks are mostly deposits by the general public, liquidity credit from Bank Indonesia, unsecured commercial papers sold to the general public (including foreigners), and equity shares owned by Bank Indonesia and other staterelated institutions. The latter include state-run pension funds (e.g., PT Taspen—civil servants’ pension fund), insurance companies (e.g., PT Jamsostek—workers’ social insurance), pension funds, and other financial

The Recent Financial Crisis in Indonesia Table 5.4 Typical Balance Sheet of a “Swindle” Bank Assets

Loans to: Principal private owners (dominant) Other borrowers (minor) Reserves

Building and equipment

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Liabilities

Deposits owned by: Private owners General public Interbank borrowings both from domestic and foreign sources Liquidity credit from BI unsecured securities: Commercial papers Others Capital: Bank Indonesia State-owned pension funds and insurance companies Pension funds of Bank Indonesia and other state-owned enterprises and banks Principal private owners (dominant)

resources self-administered by state-owned enterprises and their cooperatives. The net worth of such banks is actually negative. The newspaper reports indicate that financial problems of the recently suspended banks have been there for a long time, given that their survival was ultimately based on injections of financial resources from the central bank. The reports also indicate that Bank Indonesia was acting solely as the lender of last resort to state-owned banks and to the politically wellconnected institutions. Other state-owned enterprises were also directed by the government to invest and place deposits in banks and enterprises owned by the politically influential conglomerates. Continual funding of distressed banks by the lender of last resort (and providing funding from other public-sector institutions) often committed Bank Indonesia and the public sector to lend money to institutions that had no capital. Owners of the dysfunctional banks had no incentive to use the new money wisely because they had nothing to risk. Aside from providing equity capital and credit, Bank Indonesia also arranged mergers, consolidations, and takeovers of problem banks by either stronger institutions or new investors. The Policy Responses

Before shifting to the present exchange rate regime, Bank Indonesia had tried to defend the moving band system from the speculative attacks in July 1997 by widening the intervention band and selling foreign exchange in both forward and spot markets. To support these policies, the authorities

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Two Crucial Problems

also introduced a wide array of tight monetary policies along with administrative measures to limit external borrowings by commercial banks and discourage short-term capital inflows while maintaining open access to the economy for long-term capital, particularly FDI (Table 5.5). At the end Bank Indonesia had to abandon the moving band system (adopted in 1992 to defend its foreign exchange reserve position). This was partly because until then no clear signal had been issued by the authorities on how to solve the core of the problems—the private sector’s external debt and banking crises—and how to promote growth by improving the efficiency of the economy and boosting nonoil exports. Public confidence was further eroded because of the government’s indecisiveness about what to do with the excessive infrastructure projects owned by the well-connected business groups. These projects were shelved in September 1997 but put back in the pipeline in the following month after the availability of new loans under the IMF program signed in October 1997—but had to be shelved again under the revised IMF package of January 1998. The revised budget for fiscal 1998/99 (ending in March), announced on 24 January 1998, predicted that real economic growth would fall to 0 percent in that fiscal year (instead of 4 percent as in the original draft budget), the inflation rate would hover at around 20 percent (instead of 9 percent), the exchange rate would be 5,000 rupiahs per dollar (instead of 4,000), and the ceiling for budget deficit would be 1 percent of GDP. Mainly because of the availability of subsidies to control prices of statesold products, the actual inflation rate was a relatively modest 11.05 percent in 1997. As a percentage of GDP, the current account was expected to swing from a deficit of 2.7 percent in fiscal 1997/98 to a surplus of 1 percent in 1998/99. This improvement in the current-account balance was expected to come from the immediate impacts on the expenditure cut and depreciation of the rupiah on import reductions rather than from increasing exports. As shown in the appendix at the end of this chapter (p. 126), the original and revised IMF programs contain a broad outline of macroeconomic policy, which includes cutting domestic absorption, particularly government spending and investment. The second part of the IMF program covers a broad outline of economic reforms, including trade and investment policies, as well as a reform of the financial system in order to dissolve monopolies and open the economy to foreign competition and capital. The measures also include a reform in market structure to improve market transparency. In contrast to the previous arrangement, the 50-point IMF program of January 1998 contains more detailed measures with specific targets and timetables. Rather than injecting more liquidity into the system while weeding out the weak banks, the authorities squeezed liquidity by shifting public-sector deposits to the central bank, thus tightening monetary policy. As part of

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the conditions for receiving a $43 billion bailout from the IMF, the authorities revoked operating licenses of 16 financially distressed private banks.21 This ignited capital flight and a rush on banks as depositors withdrew their deposits from domestic banks and transferred them to foreign banks, both in Indonesia and overseas. The worsening banking crisis and continuous decrease in the external value of the rupiah raised inflation rates. Also, concern about the president’s health led to panic buying in January 1998 as housewives discarded the rupiah in exchange for staple goods. The IMF program did not specifically address how to deal with the private sector’s short-term external debt. Out of $66 billion corporate external debt outstanding, about $30 billion would fall due in March 1998. The IMF program, however, helped restore confidence on the part of the private sector to roll over maturing loans, because the reforms under the program acted as an “entrance ticket” to international financial markets. The success of the reforms to improve productivity and promote nonoil exports should loosen the tight liquidity and recover economic growth, allowing expansion of domestic aggregate demand and the resumption of foreign capital inflow. In the policy statement issued on 27 January 1998, the government proposed to temporarily freeze the servicing of private-sector external debts. It also made clear that the corporate debt problem should be solved by voluntary agreements between borrowers and lenders. The government would not provide financial resources, subsidies, or guarantees to bail out those companies that could not survive the surging real interest rates and sharp devaluation of domestic currency. Private-sector default would be permitted, including in the financial sector, since the government would neither rescue those that got into financial difficulties nor guarantee their external debts and repackage them into a government bond issue. Because creditors would certainly lose out, this reduces Indonesia’s access to international financial markets, as in the case of Peregrine. Some of the loss can be shifted to taxpayers through tax credits in the source countries.

External Reserves and Sterilization Operations

Capital inflows, in the case of Indonesia, have been used to finance both the chronic current-account deficit and the increasing demand for foreign exchange reserves. Using the balance-of-payment identity, this can be written as: (1) K = CA + ∆R

where ∆ stands for changes, K is capital inflow, CA stands for currentaccount deficit, and R is foreign exchange reserves.

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Two Crucial Problems

Indonesia holds foreign reserves to cover around 4 to 5 months of imports (see Table 5.1). According to some economic literature,22 the need for external reserves is increasing in line with the rising levels of national income, import and foreign debt, and closer integration of the national economy into that of the rest of the world. The latter exposes the economy to external shocks, such as terms of trade changes, realignment of major vehicle currencies in international trade, contagious effects of the Mexican and Thai crises of 1994 and 1997,23 and fluctuations in the capital accounts that would cause the variability of the balance of payments. The currency realignment since the mid-1980s has encouraged Bank Indonesia to diversify the currency composition of its holdings in foreign exchange in order to protect itself from rising imports and the burden of external debt. To beef up external liquidity, the central bank has also increased the stock of its standby commercial loans to presently amount to $2 billion and entered into bilateral repurchase agreements with other central banks in the Asia-Pacific region.24 Woo and Nasution25 argue that the total stock of short-term external debt should be counted as part of debt service due each year. In their view, this more inclusive definition provides a better indicator of short-term external liquidity of the economy. It is, however, unlikely that creditors would call in all short-term debt at once. Calvo26 stresses the need to build up external reserves to face financial vulnerability because of financial deepening, particularly the rapid rise in vulnerable dollar-denominated deposits at local banks, as shown by the rising ratio of M2 to GDP. In a world of fractional reserve banking systems, and implicit deposit insurance, bank deposits are contingent liabilities of the central bank and government. When capital flow fell in July 1997, Bank Indonesia began to finance the current-account deficit by running down its foreign exchange reserves. Subsequently, this helped reduce the monetary base and money supply. Formally the identity of monetary base is: (2) ∆B = ∆D + ∆R

where B is the monetary base (currency plus commercial bank reserves at the central bank), D is the domestic credit of the central bank (to government, commercial banks, and the business sector), and R, again, is foreign exchange reserves.

Sterilization Operations

Accumulation of external reserves is paid for by money created by the central bank. To keep the monetary base constant, the monetary authorities can reduce the bank’s domestic credit or the deposit money the bank lends

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by an equivalent amount. Such an operation is called sterilization because the central bank does not allow the accumulation of external reserves to be carried over to the monetary base and money supply. The operation changes only the balance between the domestic credit component and the reserve component of the monetary base, keeping the monetary base supply or the money supply constant. Sterilization in Indonesia is principally operated through sales of Bank Indonesia Certificates (SBIs).27 To help squeeze liquidity, between 22 July and 8 August 1997 Bank Indonesia raised the discount rate of SBIs four times. This increased the discount rate for 1-month SBIs from 7 to 30 percent. Such high SBI discount rates precipitated the jump in interest rates. However, the high interest rates did not attract capital inflows because of the rising Indonesian risk premium. As a result, the rise in interest rates was accompanied by a sharp depreciation of the rupiah. The measures to mop up liquidity included Bank Indonesia’s policy to stop buying SBPUs (money market securities issued by the corporate sector and endorsed by banks). The liquidity was further contracted as the Ministry of Finance instructed the public-sector (including state-owned enterprises) to shift their deposits from commercial banks to the central bank. Previously, in April, the money multiplier was reduced with the increase in reserve requirement from 3 to 5 percent. Through moral suasion, the central bank capped the growth of banks’ credit to 18 percent per annum. Except for low-cost housing, credit for land-based industry has been practically halted since early July 1997. Since they are debt instruments issued by the central bank itself, SBIs are flexible monetary instruments to be used by their issuer. Unlike government bonds, the use of SBIs is only for monetary policy objectives and unrelated to fiscal policy, debt management, and government borrowing. This strengthens the operational autonomy of Bank Indonesia, particularly when the treasury is unwilling to accept the rise in interest rates and the burden of government debt repayments. In the past, SBIs were also used to mop up the liquidity impact of the reduction in the required reserve ratio from 15 to 2 percent in October 1988. The rapid increase in the use of SBIs has also been partly due to the policies of the Ministry of Finance, which instructed large state-owned enterprises to convert significant amounts of their deposits, mainly at stateowned banks, into this instrument. Such instructions have been issued three times, in 1987, 1991, and 1997. This shifts the deposits of the public institutions to the central bank, which acts similarly to an increase in the reserve requirement on these deposits. This in turn is equivalent to a tax that is discriminatory because it is applied only to public-sector deposits. The burden of such a tax is divided between the owners of such deposits and their holders. Until October 1988, all public-sector funds

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(including those of state-owned enterprises) had to be deposited only at the seven state-owned banks. Since then, the public sector has been allowed to deposit a maximum of 50 percent of its funds at private commercial banks. As long as the money market is still underdeveloped, sterilization through shifting public-sector deposits to the central bank remains the most viable and the most powerful policy measure. Since the shifting is done through a nonmarket mechanism, it requires no well-developed money market. It is a powerful policy because, by regulation, the stateowned banks still hold at least 50 percent of public-sector deposits. Another attraction of such sterilization is the relatively cheap quasi-fiscal cost of it, as compared with the cost of sterilization through selling government bonds. The periodic use of such a policy, however, results in large and unforeseen changes in the cash base of commercial banks and thereby introduces great uncertainty into their operations. Commercial banks cannot make portfolio decisions, including lending policies, based on publicsector deposits held by them. SBIs, however, are created solely for absorbing liquidity and not to foster development of the financial market. Since the central bank has the exclusive right to issue money, it does not need to raise money by issuing debt instruments and selling them to the general public. The incentive to develop an SBI market is further eroded because of the expensive financial costs of their issuance. However, the monetary authority, Bank Indonesia, is well equipped with other instruments to affect liquidity. These include reserve requirements and access to credit facilities, affecting the foreign exchange power of the commercial banks and the exchange rate devaluation. Direct Control of Liquidity

The domestic liquidity effects of reserve asset changes also depend on the money multiplier between the base money and broad money. In the current risk-based capital system, the capacity of a commercial bank to create demand deposits is not only dependent on the traditional reserve requirement ratio. It is also a determined by a set of rigid prudential rules and regulations that include (1) capital adequacy ratio (CAR), presently set at 8 percent, and (2) the composition of the risk structure of a bank’s portfolio. The monetary authorities also define both the composition and the structure of bank capital (both core and supplementary capital), as well as a detailed and specific method to calculate risks. The portfolio structure includes the loan-to-deposit ratio which is currently set at 110 percent, and regulations on legal lending limits and net open positions of banks. Table 5.2 indicates the rapid growth of the money supply and bank credit. This was partly because of the weakness in the implementation of the rules and regulations of the banking system. As a result, the prudential

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rules could not act effectively as tools to restrain the capacity of commercial banks for making loans and creating money. Another part of the problem arose because the central bank, as the lender of last resort, continuously provided credit to bail out the distressed banks. The presence of such financially distressed banks limited the ability of the central bank to conduct monetary policy. These and the shallowness of the money market made Bank Indonesia resort to the use of direct monetary policy instruments, including credit control, reserve requirements, and liquidity ratios. These reduced the capacity of commercial banks to lend and the need for sterilization operations. Having been reduced from 15 to 2 percent in October 1988, the ratio of the reserve requirement was increased to 3 percent, effective from September 1995, and to 5 percent, beginning on 16 April 1997. Along with the reduction in the reserve requirement ratio, however, the authorities in October 1988 imposed a 15 percent tax on interest rates paid by banks to depositors, which was really the same thing.28 The only difference was that instead of the central bank’s receiving the earnings from reserve requirement, the treasury got the tax revenues. The rise in the nonremunerated reserve requirement ratio increased the central bank’s revenue from seigniorage. The increase in such an inflationary tax, however, was costly to banks and could further damage their financial positions, particularly that of undercapitalized institutions. Moreover, it widened the spread between borrowing and lending interest rates, penalizing depositors and discouraging investment. As has been pointed out, credit control included an extensive use of moral suasion to slow lending to the property sector and other sectors of the land-based industry. A set of tight rules and regulations was introduced to discourage banks’ participation in the commercial paper market. Because this was perceived as inadequate, in 1995 the authorities introduced a credit plan that set specific credit growth targets for individual banks of no more than 18 percent per annum. In addition, in December 1995 the authorities announced a set of policies to slow the growth of finance company lending. New entry to the industry was halted, and its gearing ratio— the ratio of total borrowing to net worth—was limited to 15, and to 5 for offshore loans. Issuance of promissory notes and their equity position in other companies were also restricted. Ceilings on Public-Sector External Borrowing

In October 1991, the authorities reimposed special quantitative ceilings on offshore borrowing by the public sector at large, including state-owned enterprises. The ceilings were also applied to offshore borrowings by the private-sector entities, which relied on public entities for their bankability. The control was implemented in Bank Indonesia’s regulations, which set the ceiling on commercial foreign borrowings by itself, state- and private-owned

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banks devisa, and state-owned and private companies for the 5 fiscal years ending in 1995/96 (Table 5.5). Bank Indonesia established a queuing system to obtain and use the ceilings and abolished the implicit subsidy on the premium of exchange rate swap facility. The banks were fined for failing to report external borrowings and exceeding their ceilings and net open position requirements. Effective from 1 April 1997 at least 80 percent of the offshore borrowings had to be channeled into export-related activities. The queue system allows the authorities to set the size and timing of capital inflows and check their terms and conditions as well as their uses. Quantitative restrictions or capital controls, however, are perceived as inferior to a tax on foreign borrowing, which is regarded as the first best policy. In the short run, administrative restrictions and controls are seen as devices to bring about a reduction of capital inflows quickly, without having to lower interest rates. The restrictions and controls are also an effective tool to change the composition of capital inflows in the short run. In the longer run, however, quantitative controls on capital movements have several major disadvantages. Because they are inevitably involved with nonprice rationing, they result in very different effective rates of tax on different domestic borrowers. They are administratively cumbersome, and there is some potential policy rigidity or pressure-group activity, which ensures that once restrictions are imposed, they are not eased or removed when the original macroeconomic reasons have gone. Because of such macroeconomic crisis-protection ratchet effects, the capital controls are subject to abuse and dissipation in inducements to rent seeking since allocation of such quantitative controls is based on nonprice mechanisms. The principal alternative policy of less distortion, such as the “Tobin tax,”29 can be temporarily introduced to help discourage the motivation to shift capital around. As a strategy to “throw sand in the wheels” of the relatively efficient currency market, Tobin30 has proposed imposing “an Table 5.5 Ceilings on Foreign Commercial Borrowing, 1991/92–1995/96 (millions of U.S. dollars) Bank Indonesia State banks Private banks Private companiesa Total

1991/92 400 1,000 500 2,500 5,900

1992/93 500 1,000 500 2,600 5,600

1993/94 500 1,000 500 2,700 5,900

1994/95 500 1,000 500 2,800 6,200

1995/96 500 1,000 500 2,900 6,500

Sources: World Bank, 1996, Indonesia, Dimensions of Growth. Country Department III, East Asia and Pacific Region, Report 15383-IND, 7 May, Table 1.5, p. 11. Note: a. This is not a binding ceiling. Under the current exchange rate system, the private sector is asked only to report its transactions with foreigners, but there is no fine or legal consequence for not doing so.

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internationally uniform tax on all spot conversions of one currency into another, proportional to the size of the transaction.” The tax includes a nonremunerated reserve requirement deposit at the central bank on deposits associated with direct borrowing in foreign currency.31 The tax would be an insignificant burden for exchanges in goods-and-services markets, labor markets, and long-term capital investments. It, however, would significantly add to the cost of short-term arbitrage to reduce speculative transactions. The proceeds from such a tax would increase government revenue and could be used to reduce speculative transactions and exchange rate volatility. Because it would hurt the currency speculators more than traders and investors, the Tobin tax would control erratic exchange rate volatility and attract the attention of direct traders to the long-run fundamentals and away from transient contagious market sentiment. A variant of the Tobin tax has been proposed by Spahn32—that the tax should only be applied to currency conversions that occur when the exchange rate moves beyond some band. The Spahn tax is equivalent to the difference between the band and the market exchange rate. From a microeconomic point of view, the Spahn tax internalizes externality associated with currency instability into currency prices. It is true that the feasibility of collecting the Tobin-Spahn tax depends on the existence of an international agreement for cooperating in collecting it within national borders. As of now, a tax on short-term capital inflows is not covered in double-taxation treaties between nations. However, such a transaction tax (particularly the reserve requirement deposit associated with external borrowings) can be unilaterally imposed in one country. The tax rate should not be too high because it may act as a disincentive to borrow overseas, particularly on short-term maturities. Moreover, the high tax can be avoided or rerouted through other channels. These include overinvoicing of imports or underinvoicing of exports when export credits are exempted from the tax. Again, since excessive capital inflows are a temporary phenomenon, the tax ratio should be immediately readjusted once short-run capital inflows return to a more manageable level.

Fiscal Policy

Before the present crisis, there were two sound fiscal measures that had been adopted by the authorities to reduce the burden of repayment of external debt. The first was to ease external debt repayment by using the proceeds from the privatization of state-owned enterprises to retire expensive external debt, which carried interest rates exceeding 10 percent per annum. Since the 1994/95 fiscal year the government has prepaid $1.5 billion of such high-cost debt, reducing the amount of outstanding public debt by 2

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percent. The second was to reduce reliance on external borrowing by introducing an expenditure-reducing policy, particularly measures to restrain public investment demand and consumption. Traditionally, the structure of the cut in public expenditures has been designed to protect activities that are likely to produce high rates of returns and that are crucial for long-term growth. These activities include investment in essential economic infrastructure projects and in human resource development. Since public expenditures are mainly to be spent more on such nontraded goods, the structure of the cut in the public budget also helps avoid an appreciation of the real exchange rate.33 This rule, however, was violated to some extent because the authorities protected investment in “strategic” industries, the national car program, and excessive infrastructure projects, all of which required high protection from imports and scarce foreign exchange and skilled manpower. The fiscal situation was further strengthened through greater tax collection efforts and improvement in the operations of state-owned enterprises. The tightening of fiscal policy immediately reduced government formal budget deficits and increased public-sector savings. While formally maintaining the balanced budget principle, in reality, the government was running an annual budget surplus of between 0.2 and 0.8 percent of GDP since fiscal 1993/94. Until recently, the sound measures in the formal budget, however, were accompanied by rapid expansions of “off-budget” expenditures to finance ambitious industrial projects. Banking Restructuring

The IMF program contains seven measures to restructure the banking system. The first is to encourage distressed banks to merge34 rather than letting them fail. The second is to strengthen the capital base of the bad banks by allowing new investors, including foreigners, to inject capital. Foreign institutions are expected to help in packaging the bad debts and to bring in expertise. Third is that the process of banking restructuring will be assisted by the IBRA, which is supposed to be an independent agency under the Ministry of Finance. The IBRA has two main functions: (1) to supervise the banks in need of restructuring and manage the restructuring process, and (2) to manage assets required in the course of bank restructuring. The agency has a limited life span, and will be closed once the bank rehabilitation program is completed. Fourth is to make the operations of state-owned enterprises, including state banks, more transparent and accountable. The performance by state banks’ managers will be judged according to criteria detailed in performance contracts. Political corruption can be significantly reduced by making state-owned enterprises more independent and cutting their links to government bureaucracies.

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The fifth is to strengthen Bank Indonesia, which will be immediately given full autonomy in formulating and implementing monetary policy. Sixth is market infrastructure, including the prudential rules and regulations concerning the financial system that will be improved, along with measures to strengthen the capability of Bank Indonesia to supervise the banking industry and enforce the prudential regulations. The seventh is to restore the confidence of domestic and international communities in domestic banks. The authorities will explicitly provide full guarantees on demand, saving, and time deposits of all banks operating in Indonesia. Government guarantees are also to be extended to cover credit received, guarantees, and letters of credit issued by the banks. The credit received by the bank owners and subordinated debts, however, are not covered by the scheme. In 2 years’ time, the scheme will be taken over by a Deposit Insurance Scheme, to be administered by the IBRA. In the short run, the availability of such schemes will reduce runs on banks, which happened following the closure of 16 banks in early November 1997. In exchange for the guarantees, all locally incorporated banks will be subject to enhanced supervisory oversight. Those that fail to meet Bank Indonesia standards are to be reviewed by the IBRA. The scheme is expected to restore the confidence of the international community, which has refused to accept letters of credit opened by Indonesian banks. In the long run, however, the credit insurance scheme will create moral hazard problems, particularly when there is a relatively weak economic infrastructure. Government bonds will be issued to raise funds for financing the initial operation of the IBRA. Over time, as recoveries increase, the IBRA will be able to become more self-financing. The participating banks will be required to contribute a half-year fee of 0.05 percent of the guaranteed deposits and debts to the government guarantee scheme. The fund used by Bank Indonesia to bail out depositors and creditors will be credited to the government annual budget in tranches for 5 years. The combined balance sheet of commercial banks shows that the demand deposits at these banks in November 1997 stood at 356.4 trillion rupiahs (of which 53 trillion were valued at the then exchange rate of 3,432 rupiahs per U.S. dollar). There is no information on the size of other banks’ liabilities, including contingent liabilities. According to Bijan B. Aghevli, the IMF deputy director for Asia-Pacific, the costs of the government’s guarantees on deposits and debts in the banking sector was equivalent to between 10 and 12 percent of Indonesia’s GDP.35 Conclusions

Overinvestment in the nontraded sector and the manufacturing industry— requiring high protection—and a weak financial system are the roots of the present financial crisis. Such investment was funded by massive capital

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inflows, as shown by widening current-account deficit and mounting external debt. Overinvestment in less efficient investment projects implied that fewer resources were being devoted to enlarging productive capacity of the economy to raise the perceived ability to service and reduce external liabilities. Moreover, the overinvestment caused other distortions, such as asset overvaluation, as is evident in the real estate sector. The changing composition of the capital inflows significantly added to the vulnerability of the system as a whole. This was because the share of the capital inflows in the form of short-term bank borrowings and portfolio flows invested in the stock market and in private-sector instruments was rapidly expanding. Surging local interest rates and the deep depreciation of the rupiah raised the cost of renewing or rolling over short-term floatingrate dollar and yen loans in real terms. To some extent, the authorities influenced both the size and the composition of the volatile short-term capital inflows by imposing ceilings on them and by raising their costs. The financial system, particularly the banking system, was plainly dysfunctional because of a combination of a rotten central bank and direct government intervention in the selection of the banks’ credit customers. The private-sector banks also faced the risk of moral hazard behavior because they did not act firmly with their sister companies within the same business group. Rebuilding the system required measures to strengthen both the central bank and commercial banks. State-owned banks (including state-owned nonbank enterprises) needed to be delinked from the government bureaucracy and corporatized. In addition, market infrastructure needed to be improved to enforce the implementation of prudential rules and regulations and promote competition and strict credit policies. Because an indirect policy, especially through implementation of prudential rules and regulations, was relatively unable to restrain expansion of the liquidity and the current-account deficit, the authorities resorted to the use of direct administrative controls. These included the elimination of subsidies for an exchange rate swap facility and the reinstitution of ceilings on external borrowing by the public sector. The link between the base money and broad money was weakened with the rise in the nonremunerated reserve requirement ratio and the introduction of a credit plan that directly set specific credit growth targets for individual banks. Previously, moral suasion was applied only to institutions lending to land-based industry. To support sterilization operations the Ministry of Finance again forced state-owned enterprises to shift their deposits, mainly those in stateowned banks, into the central bank’s deposits. This dried up liquidity in the economy. Fiscal adjustment has been the key component of the stabilization and adjustment programs in Indonesia. On the revenue side, the widening of the tax base following the tax reforms of the early 1980s and in 1995 made

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an important contribution to enhancing fiscal flexibility. Meanwhile, the removal of egregious marginal tax rates and the replacement of a cascading sales tax with a more neutral value-added tax has helped raise economic efficiency and improve external competitiveness. To ease the external debt burden, the authorities have used windfalls from oil revenue and proceeds from the privatization of state-owned enterprises to retire expensive external debt. The restraint in the formal budget has not been accompanied by the same discipline as in nonbudget expenditures. The massive capital inflows have also appreciated the external value of the rupiah. This reduced the competitiveness of the domestic economy in the international market and further provided incentives to invest in the nontrade sector of the economy. Because it was not supported by proper fiscal and monetary policy and lacked a healthy banking system, Indonesia abandoned the moving exchange rate band system on 14 August 1997 and shifted to the floating exchange rate system. The economic costs of such measures are likely to be severe because of the sharp depreciation of the rupiah, punitive interest rates, a plunge in the index of share prices, and an acute liquidity crunch. All of these will cause bankruptcies for both banks and their customers, a lower growth rate, and a rise in both unemployment and inflation. Such an economic recession depresses investment and pushes down asset prices. The revised IMF program announced on 15 January 1998 focused on further reform in trade and investment policies, the financial system, and market infrastructure. The program was a good start to strengthen economic institutions, improve domestic competition, increase efficiency, and remove distortions that restrain exploitation of Indonesia’s comparative advantage in the labor-intensive and natural-resource-based sectors. To restore public confidence in the banking system the authorities provided government guarantees for claims by depositors and creditors of banks operating in Indonesia. The confidence will speed up with the progress of the bank-restructuring program. The social and political costs of the adjustment program are, however, likely to be very high. Aside from providing financial incentive to traded goods and exports, devaluation will raise inflation rates. The contraction in domestic expenditures and economic growth, along with rising bankruptcies, will push up unemployment. The distributive effect of the adjustment program is partly influenced by the structure of the expenditure cut. As of this writing, all the above problems have already begun to take place. And these, along with the closing of 16 financially distressed private banks in November 1998, have aggravated the problems, igniting runs on banks, capital flight, buying panic, and reluctance by foreign banks to accept Indonesian letters of credit. Even domestic banks have become reluctant to lend to each other.

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The IMF program does not specifically address how to deal with the private sector’s short-term external debt. The IMF program, however, helps restore confidence on the part of the private sector to roll over maturing loans because the reforms under the program act like an “entrance ticket” to international financial markets. As stated earlier, confidence will be further restored with the progress in bank restructuring, thus raising productivity and promoting nonoil exports, as tight liquidity is loosened, and recovering economic growth. These measures will allow expansion of domestic aggregate demand and resumption of inflows of foreign capital. In the policy statement issued on 27 January 1998 the government proposed a temporary freeze on servicing the private sector’s external debt. The authorities also made clear that the corporate debt problem should be solved by voluntary agreements between borrowers and lenders. The government would not provide financial resources, subsidies, or guarantees to bail out those companies that could not survive the surging real interest rates and the sharp devaluation of domestic currency. Privatesector default will be permitted, including in the financial sector, because the government would not rescue those that got into financial difficulties. The vigorous economic reform, including restructuring in financial and corporate sectors, is likely to raise productivity and production and promote nonoil exports to lead economic recovery in the medium and long run. The crisis can be easily overcome because the sound fundamentals for economic growth (including vigorous entrepreneurs, skilled labor, adequate economic infrastructure, and a relatively high saving rate) are still in place. This prospect, however, also depends on financial conditions, and working capital is now an important but scarce ingredient hampered by tight liquidity. Appendix 5.1: Chronology of Policy Response to Speculative Attacks, March 1997–January 1998

1997 March 26: Tightening of administrative measures concerning foreign borrowings by commercial banks (ceilings, market entry, net open position, reporting, use of credit and fines). It is required, among other things, to use at least 80 percent of the external borrowing for financing exportrelated activities. April 16: Reserve requirement ratio raised from 3 percent to 5 percent.

July 2: Commercial banks asked to stop credit for land-based industry, except for low-cost housing.

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July 11: Widening of intervention band from 192 rupiahs (8 percent of the central rate) to 304 rupiahs (12 percent of the central rate). July 20–22: Bank Indonesia intervenes with $1.02 billion in forward foreign exchange market.

July 22–August 18: Bank Indonesia raises discount rates of Bank Indonesia certificates (SBIs) four times from 7 to 30 percent per annum.

August 13: Bank Indonesia intervenes with $0.5 billion in spot foreign exchange markets.

August 14: Bank Indonesia abandons the moving exchange band system and replaces it with a floating system.

August 14: The minister of finance instructs the public sector (including state-owned enterprises) to shift their deposits from commercial banks (mainly from the state-owned ones) to Bank Indonesia. This withdraws liquidity of at least 12 trillion rupiahs from the economy.

August 31: The minister of finance imposes a limit on foreign exchange transactions to $5 million per customer per bank, except for investment and trading purposes.

September 3 and 20: The minister of finance revises the state budget and postpones $37 billion worth of 244 public-sector-related projects, especially those requiring heavy imports. The authorities, however, reaffirm policies to continue the aircraft and other strategic industries under the Ministry for Research and Technology and the national car project. Fourteen infrastructure projects, mostly owned by Suharto family members, are reactivated in November.

September 4: The minister of finance lifts the 49 percent limit on stake of foreign ownership in new stock offerings at local stock exchanges.

September 17: The minister of finance cuts import tariffs for 153 groups of commodities.

October 3: Bank Indonesia reintroduces a foreign exchange swap facility for exporters and a forward facility to import inputs needed for production of nonoil export products.

October 6: Bank Indonesia sells another $650 million in the foreign exchange market to stabilize the external value of the rupiah.

October 8: Professor Widjojo Nitisastro, the presidential economic advisor, is empowered to take all necessary actions in coordination with the responsible agencies, and request assistance from the IMF, the World Bank, and the Asian Development Bank (ADB) to overcome the currency crisis and help strengthen the financial sector.

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October 30: Indonesia reaches an agreement with the IMF on a financial and economic reform package. The funding commitments amount to nearly $43 billion ($23 billion in first-line funding and nearly $20 billion in second-line resources). The sources of the first-line financial resources are $10 billion from the IMF, $4.5 billion from the World Bank, $3.5 billion from ADB, and $5 billion from Indonesia’s own resources. The sources of second-line credit are bilateral loans from six countries. The IMF package has two components, namely, a broad outline of macroeconomic policy targets (for economic growth, inflation rate, currentaccount deficit, and fiscal balance) and a broad outline of economic reform measures covering trade, investment, financial institutions, and market infrastructure. The trade policy reform includes elimination of the BULOG monopoly, effective from 1 January 1998, on the import of wheat, wheat flour, soybeans, and garlic. The industry policy reform includes elimination of the local-content program for automobiles by the year 2000 and implements the WTO’s decision on the national car project. The banking policy reform includes the suspension of operating licenses of 16 commercial banks announced on 1 November 1997. This is followed by announcements made in January to merge four state-owned banks and major private banks. Even if the IMF did not insist on closing the distressed banks as a condition for aid, the banks are dying anyway: their net worth is negative simply because they have lost a lot of money.

November 21: Having met the president, the chairman of the Indonesian Chamber of Commerce (KADIN) announces that, to ease liquidity, the head of state has instructed monetary authorities to disburse a $5 billion standby loan from Singapore and has ordered state-owned companies to use 1 percent of their net profits to buy shares on the Jakarta Stock Exchange. At this time, the president is visiting Cape Town, South Africa, on the way to the APEC summit meeting in Vancouver, Canada. Previously, on 17 November, the president had instructed the state-owned social insurance firm (PT Jamsostek) to deposit 1 trillion rupiahs of its funds in the state-owned Bank Tabungan Negara (BTN) at lower than prevailing market rates to enable the latter to finance low-cost housing. In addition, PT Jamsostek is instructed to deposit another 2 trillion rupiahs ($588 million) in state-owned banks at 14 percent interest per annum to enable the latter to provide credit at 17 percent interest to small-scale firms.

December 31: The government announces a policy to solve the problems of state-owned banks by (1) the merging of four major state banks into one single institution by the end of June 1988; (2) privatization of state-owned banks; (3) greater participation by foreign institutions in owning their equity shares; and (4) resolution of their bad debts.

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1998 January 6: The government presents Parliament with a draft budget for fiscal 1998/99, beginning 1 April 1998. The proposed budget, amounting to 133 trillion rupiahs, is a 32.1 percent increase compared with the previous year’s budget of 101 trillion rupiahs. The draft budget is based on the “balanced budget” principle, which limits the size of the budget deficit to the level that can be financed by foreign aid and loans, and is calculated based on unrealistic assumptions, such as on exchange rate (4,000 rupiahs to the U.S. dollar), an annual rate of growth of 4 percent, a low inflation rate, and oil export prices at $17 per barrel ($2 below the average market price in January 1998).

January 15: In a public ceremony and witnessed by Michel Camdessus, the managing director of the IMF, President Suharto personally signs a two-page letter of intent pledging to the IMF to carry out a 50-point memorandum containing details of the economic measures the government would introduce. The new agreement strengthens the IMF package signed on 30 October 1997. For fiscal policy, the new agreement calls for revision of the draft budget for fiscal 1998/99 presented to Parliament on 6 January 1998. The deficit in the revised budget, announced on 24 January, is capped to 1 percent of GDP. To achieve this target the government should reduce its expenditure by, among others, eliminating fuel and electricity subsidies and by raising government revenues. Nonbudget expenditures, such as the investment fund and the reforestation fund, should be incorporated into the central government budget. Special taxes, customs or credit privileges, and budget and extrabudgetary supports to the national car and aircraft projects are immediately discontinued. Bank Indonesia should continue a tight monetary policy to strengthen the legal and supervisory framework for banking and the capability of Bank Indonesia to administer them. The existing banking law would be amended to make Bank Indonesia an independent institution to allow full privatization of state-owned banks, greater participation by foreign investors in the ownership of domestic banks, and the opening of more branch offices by existing foreign banks. Domestic competition is to be improved by eliminating cartel-like marketing arrangements, including those in plywood, cloves, cement, paper, and steel. BULOG’s monopoly will be limited to rice. Restrictions are to be eliminated on investment and foreign trade, including those on foreign investment in palm oil, wholesale and retail trade, all new and used ships, and marketing arrangements. Local-content regulations, export quotas, export bans, punitive export taxes, and local taxes on export goods are to be liberalized or dropped. State-owned enterprises are to be restructured and a program of privatization is to be accelerated.

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To help ease the burden of the poor, community-based programs would be introduced, and the programs for least developed villages would be expanded. A number of programs would be introduced and implemented to strengthen the overall environment. January 21–24: To comply with the revised IMF standby arrangement, the authorities announced on 21 January a series of measures to reform trade and investment policies, financial institutions, and state-owned enterprises. A revised proposed budget for fiscal 1998/99 was announced on 24 January. The proposed budget is set at 147.2 billion rupiahs, a 46 percent increase as compared with the past year’s budget.

January 27: To restore public confidence in the banking system, the authorities provide a full guarantee on deposits (demand, saving, and time deposits) at all banks operating in Indonesia as well as the banks’ debts (credit received, guarantees, and letters of credit). The government guarantees, however, exclude debts of bank owners and subordinate debts. In 2 years’ time, the guarantees will be taken over by the Deposit Insurance Scheme, soon to be established. It is also announced that the government is going to establish the Indonesian Bank Restructuring Agency (IBRA), an independent institution under the auspices of the Ministry of Finance. IBRA has two main functions: (1) to supervise the banks in need of restructuring and manage the restructuring process, and (2) to manage the banks in the course of the bank restructuring. The government proposes to temporarily freeze the servicing of corporate external debts, which include financial loans (bank loans, bonds, commercial papers, and similar debt instruments), excluding trade-related debts. A steering committee of creditors and a contact committee of debtors are to be prepared to work together to resolve the corporate debt problem, based on voluntary agreements between borrowers and lenders. The government makes clear that there will be no use of public financing, guarantees, or subsidies to bail out the indebted and unguaranteed creditors that look for redress (thus acting as in any normal case of insolvency). The steering committee is to consist of senior international bankers from the main creditors’ countries, while the contact committee would consist of executives from 228 local indebted companies. Private-sector default would be permitted, including in the financial sector. Notes

1. Jakarta Post, 9 January 1998. 2. Prior to, during, and after the financial crisis, the governor of Bank Indonesia and the economic ministers kept saying that Indonesia had a solid and strong economic base. However, it is not clear what they meant.

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3. The exchange rate policy includes devaluation, speedup of depreciation of the rupiah, widening of the intervention band, and raising of transaction costs in the foreign exchange markets. 4. These include staple foods (such as rice, sugar, and wheat flour), building materials (such as cement), energy (such as electricity and petroleum products), and services (such as transportation fares and school tuition). 5. This is lower than the fiscal surplus of 2 percent of GDP as suggested by the World Bank, Indonesia: Dimensions of Growth, Report No. 15383-IND, Country Department III, East Asia and Pacific Region, 7 May 1996. 6. Hamid Faruquee and Aasim M. Husain, “Savings Trends in Southeast Asia: A Cross-Country Analysis,” IMF Working Paper WP/95/39, April 1995. 7. The national car project policy was promulgated in Presidential Instruction No. 2/1996, which gives “pioneer” status to PT Timor Putra National. This exclusive status exempts the company from paying 65 percent maximum import duties for car spare parts, 35 percent maximum import duty, and luxury goods sale taxes that make up over 60 percent of the cost of car production in Indonesia. While completing its own production and assembly capacity in Indonesia, the company is allowed to import the first 45,000 units of buildup cars from KIA of Korea. To boost the sale of the car, the public sector is required to buy it. In return, the company promises to manufacture in stages the national car with the use of local components, beginning with 20 percent in the first year of its operation, over 40 percent in the second year, and over 60 percent in the third year. Fully backed by the government and Bank Indonesia, a consortium of four state-owned banks and 12 private domestic banks extended $960 million in credit to the company for building a car production and assembly facility. PT Timor Putra is jointly owned by Hutomo Mandala Putra, the youngest son of President Suharto, and KIA Motor Corporation of South Korea. 8. J.P. Morgan, Global Data Watch, 16 January 1998, p. 70. 9. Anwar Nasution, The Banking System and Monetary Aggregates Following Financial Sector Reforms. Lessons from Indonesia, Research for Action 27 (Helsinki: UNU/World Institute for Development Economics Research [UNU/ WIDER], 1996). 10. The open capital-account system was partly adopted because Indonesia has no effective and efficient bureaucracy to administer capital control. Singapore, the regional financial center, is located right in the middle of the archipelago country of Indonesia, which consists of more than 17,000 islands. 11. “The Hunt Is Over,” Time, 26 January 1998, pp. 14–16. 12. Since 1969, the economy has grown on average by 6 to 7 percent a year, with an annual per capita GDP growth of over 4 percent. Nonoil GDP (covering the economic sectors toward which most capital inflows are directed) grew by 7.7 percent annually between 1991 and 1995. Along with this rapid rate of economic growth, the amount of the population living in absolute poverty fell to 15 percent in 1990 from 29 percent in 1980 and 60 percent in 1970. The rapid economic growth has coincided with a major shift in the structure of the economy from one highly dependent on a small group of primary commodities, particularly oil and natural gas, to one with a wider range of primary commodities and manufactured products. The development strategy, which promotes investment and nonoil exports, is partly reflected in the large share of capital goods and raw materials as a proportion of total import of goods and services. The increasing openness of the economy to international markets and the broadening base of exports raise the capacity of the economy to service external debt, as debt service absorbs a lower fraction of total exports. Moreover, diversification of nonoil export products has significantly reduced the vulnerability of export revenues to commodity price swings.

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13. G. Calvo, “Comment on Dornbusch and Werner,” Brookings Papers on Economic Activity, no. 1 (1994). 14. Frederic S. Mishkin, “Understanding Financial Crises: A Developing Country Perspective,” Annual World Bank Conference on Development Economics 1996 (Washington, D.C.: The World Bank, 1997). 15. J.P. Morgan, 1997. Emerging Markets Data Watch, 1 July 1997, p. 3; and J.P. Morgan, Global Data Watch, 16 January 1998, p. 70. 16. World Bank, Indonesia: Dimensions of Growth, 1996. 17. This is through networks of ownership, and business and management, because of their strategy of being highly leveraged, which may have been suitable in the past era of subsidized interest rates and highly protected domestic markets. Nasution, The Banking System, pp. 185–186. 18. Jakarta Post, 28 August 1997. 19. R. I. McKinnon and H. Pill, “Credible Liberalization and International Capital Flows: The Overborrowing Syndrome,” in T. Ito and A. O. Krueger, eds., Financial Deregulation and Integration in East Asia (Chicago: Chicago University Press, 1996). 20. Mishkin, “Understanding Financial Crises.” 21. This includes a number of banks owned by Suharto family members. One of the closed banks, PT Bank Jakarta, brought the case to the Administrative Court in Jakarta and won. The bank is owned by the half-brother of the president. Bambang Trihatmojo, the second son of the president, simply transfers the assets and liabilities of his suspended Bank Andromeda to Bank Alfa, the newly acquired bank in his widely diversified Bimantara Group. 22. Grilli and Roubini, 1990. 23. Bank Indonesia spent $580 million in January 1995 to defend speculative attacks on the rupiah following the Mexican financial crisis in 1994 (Bank Indonesia, Report for the Financial Year 1994/95, p. 23) and lent the same amount to Thailand for financing the adjustment program following the baht crisis in July 1997. 24. The central banks of Malaysia, Singapore, Thailand, the Philippines, Hong Kong, and Australia under the EMEAP (Executive Meeting of East Asia and Pacific) central banks. The organization was established in February 1991 and other members of it are New Zealand, Japan, Republic of Korea, and People’s Republic of China. In addition to cooperation on central bank facilities there are two other objectives of the EMEAP, namely, financial market development and banking prudential supervision to improve flow of information. The Thai crisis in mid-May 1997 was the first test of the EMEAP, and has been hailed as a success as the region’s central banks were united in defending the baht from speculators’ attack. This allowed the authorities to buy time for addressing the problems of the Thai economy: a large current-account deficit, fragile banking system, and rigid exchange rate regime. 25. Wing Thye Woo and Anwar Nasution, “Indonesian Economic Policies and Their Relation to External Debt Management,” in J. D. Sachs and Susan M. Collins, eds., Developing Country Debt and Economic Performance, An NBER Research Project Report, Vol. 3, Book I (Chicago: Chicago University Press, 1989), p. 132. 26. Calvo, “Comment on Dornbusch and Werner.” 27. Over 84 percent of the outstanding money market instruments traded in December 1995 (16 trillion rupiahs) was in SBIs, and the rest was in SPBU and other instruments. Having been inactive for some time, the use of SBIs was reactivated in 1984. This was followed by the introduction of private-sector commercial papers (SBPUs) and large-denomination negotiable certificates of deposit (CDs) in 1985.

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The SBPUs consist of promissory notes issued by banks or nonbank financial institutions in connection with interbank borrowing and bills of exchange issued by third parties and endorsed by eligible financial institutions. All the CDs are issued by domestic banks in rupiahs. Other instruments used are repurchase agreements and banker acceptances. The privately owned credit-rating agency was established in 1995. The treasury has not floated bonds in the domestic markets because the government adopts a policy for capping the public-sector budget deficit to the level that can be financed by the concessionary development aid package. On 1 June 1993 Bank Indonesia allowed the market forces to determine the interest rate of SBIs. Since then, the central bank’s auction system of SBIs has been changed from a cutoff rate to a stop-out rate. The former is equivalent to “price” control, since the authorities predetermine the yield for each auction. In the latter, the central bank sets maximum and minimum yields for each auction. Concurrently, Bank Indonesia has introduced a number of measures to make SBIs more liquid and added the number of its market makers. 28. Paul Meek, “Central Bank Liquidity Management and the Money Market,” in G. Caprio, Jr. and P. Honohan, eds., Monetary Policy Instruments for Developing Countries, A World Bank Symposium (Washington, D.C.: The World Bank, 1991). 29. James Tobin, “A Proposal for International Monetary Reform,” Eastern Economic Journal 4 (July 1979): 153–159; Paul Bernd Spahn, “International Financial Flows and Transactions Taxes: Surveys and Options,” IMF Working Paper WP/95/60, June 1995; Barry Eichengreen, James Tobin, and Charles Wyplosz, “Two Cases for Sand in the Wheels of International Finance,” Economic Journal 105 (January 1995): 162–172. 30. Tobin, “A Proposal for International Monetary Reform.” 31. Chile imposes a 30 percent reserve requirement ratio on gross inflows to be deposited with the central bank for 1 year. 32. Spahn, “International Financial Flows.” 33. Helmut Reisen, “Managing Volatile Capital Inflows: The Experience of the 1990s,” Asian Development Review 14, no. 1 (1996): 72–96. 34. On 31 December 1997 the authorities announced the plan to merge four state-owned banks (Bapindo, Bank Dagang Negara, Bank Bumi Daya, and Bank Exim) into a single institution. This was followed by the announcement of several private banks’ following suit in January 1988. Bank Internasional Indonesia (BII) and Bank Dagang Nasional Indonesia (BDNI), two of Indonesia’s largest private banks, have agreed to merge with three other smaller banks (Bank Tiara Asia, Bank Sahid Gajah Perkasa, and Bank Dewa Ruci). Four banks (Bank Duta, Bank Tugu, Bank Umum Nasional, and Bukopin—Bank Umum Koperasi) owned by President Suharto’s four foundations are to be merged into one bank. The widely diversified Bakri Group was to merge its four banks in February. Tirtamas Group was expected to merge its three banks, and Ramako Group is to do the same with its two banks. 35. “Government Guarantees Bank Deposits,” Jakarta Post, 28 January 1998.

Bibliography

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Claessens, Stijn. M. P. Dooley, and Andrew Warner. “Portfolio Capital Flows: Hot or Cold?” World Bank Economic Review 9(1) (1995): 153–174. Dornbusch, Rudiger, I. Goldfajn, and R. O. Valdes. “Currency Crises and Collapses.” Brookings Papers on Economic Activity (February 1995), pp. 219– 270. Eichengreen, Barry, James Tobin, and Charles Wyplosz. “Two Cases for Sand in the Wheels of International Finance.” Economic Journal 105 (January 1995): 162–172. Faruqee, Hamid, and Aasim M. Husain. “Savings Trends in Southeast Asia: A Cross-Country Analysis.” IMF Working Paper WP/95/39 (April 1995). Frankel, J. A. 1994. “Sterilization of Money Inflows: Difficult (Calvo) or Easy (Reisen)?” IMF Working Paper 159. IMF. 1997. IMF Approves Stand-By Credit for Indonesia. Press Release No. 97/50 (5 November 1995). J.P. Morgan. Emerging Markets Data Watch (July 1997). Kaminsky, Graciela, Saul Lizondo, and Carmen M. Reinhart. Leading Indicators of Currency Crises. Working Paper No. 36. Center for International Economics, Department of Economics, University of Maryland at College Park (September 1997). Lindgren, C-J., G. Garcia, and M. I. Saal. Bank Soundness and Macroeconomic Policy. Washington, D.C.: IMF, 1996. McKinnon, R. I., and Pill, H. “Credible Liberalization and International Capital Flows: The Overborrowing Syndrome.” In Financial Deregulation and Integration in East Asia, edited by T. Ito and A. O. Krueger. Chicago: Chicago University Press, 1996. Meek, Paul. “Central Bank Liquidity Management and the Money Market.” In Monetary Policy Instruments for Developing Countries, edited by G. Caprio, Jr. and P. Honohan. A World Bank Symposium. Washington, D.C.: The World Bank, 1991. Mishkin, Frederic S. “Understanding Financial Crises: A Developing Country Perspective.” Annual World Bank Conference on Development Economics 1996. Washington, D.C.: The World Bank, 1997. Nasution, Anwar. The Banking System and Monetary Aggregates Following Financial Sector Reforms. Lessons from Indonesia. Research for Action 27. Helsinki: UNU/World Institute for Development Economics Research (UNU/ WIDER), 1996. Radelet, Steven. “Indonesian Foreign Debt: Headed for a Crisis or Financing Sustainable Growth?” Bulletin of Indonesian Economic Studies 31(3) (1995): 39–72. Reisen, Helmut. “Managing Volatile Capital Inflows: The Experience of the 1990s.” Asian Development Review 14(1) (1996): 72–96. Sachs, Jeffrey, A. Tornell, and A Velasco. “Financial Crises in Emerging Markets: The Lessons from 1995.” Brookings Papers on Economic Activities (January 1996): 147–196. Spahn, Paul Bernd. “International Financial Flows and Transactions Taxes: Surveys and Options.” IMF Working Paper WP/95/60 (June 1995). Tobin, James. “A Proposal for International Monetary Reform.” Eastern Economic Journal 4 (July 1979): 153–159. Woo, Wing Thye, and Anwar Nasution. “Indonesia Economic Policies and Their Relation to External Debt Management.” In Developing Country Debt and Eco-

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nomic Performance, edited by J. D. Sachs and Susan M. Collins. An NBER Research Project Report. Vol. 3, Book I. Chicago: Chicago University Press, 1989. Woo, Wing Thye, Bruce Glassburner, and Anwar Nasution. Macroeconomic Policies, Crises, and Long-term Growth in Indonesia, 1965–90. Washington, D.C.: The World Bank, 1994. World Bank. Indonesia: Dimensions of Growth. Report No. 15383–IND. Country Department III, East Asia and Pacific Region (7 May 1996).

6 The Financial Crisis in Korea: From Miracle to Meltdown? Yung Chul Park

Korea’s financial crisis has been as dramatic as it has been unexpected. In fact, over a 2-month period, from October to December 1997, Korea was reduced from being the world’s 11th largest economy to an economy surviving on overnight loans from the international money markets. What was so surprising about the crisis was that as late as October no one, including the international credit rating agencies, could have predicted that only 2 months later the foreign exchange market would collapse and that the Korean won would fall by more than 50 percent against the U.S. dollar between 19 November, when Korea decided to approach the IMF for a rescue plan, and 24 December (see Figures 6.1 to 6.3). During the same period, the stock price index (KOSPI) tumbled to almost 350 from 498, and the short-term market rate of interest shot up to 40 percent per annum (see Figures 6.4 to 6.7). Despite the IMF’s rescue package and Korea’s commitment to the clearing of nonperforming loans and the restructuring of troubled financial institutions, together with other badly needed economic reforms, Korean banks suddenly found themselves cut off from the international financial markets. During the last week of December 1997, Korea was on the verge of defaulting on its foreign debts. It narrowly avoided that fate by working out a last-minute emergency loan package put together by the IMF and several of the G-7 countries. Although Korean banks have been able to roll over some of their short-term debts, and market sentiments have seemingly once again begun to turn in Korea’s favor, much remains for Korea to do toward normalizing its ties to the international financial markets. At this writing, the IMF program has not been as successful as originally expected in improving the markets’ confidence in the Korean economy. The purpose of this chapter is to analyze both the internal and external factors responsible for, and the consequences and policy responses to, the financial turmoil plaguing Korea today. I first describe the buildup to the 137

138

Two Crucial Problems

Figure 6.1 Foreign Exchange Rate

Source: Korea Institute of Finance.

Figure 6.2 Foreign Exchange Rate

Source: Korea Institute of Finance.

The Financial Crisis in Korea

139

Figure 6.3 Nominal and Real Exchange Rate

Sources: Bank of Korea, Monthly Bulletin, various issues; IMF, International Financial Statistics, various issues. Note: Real and nominal effective exchange rates are estimated by the following formula: Nominal effective exchange rate (NEER) =

ΣWiei (Σ Wi Pif ) ⁄Pi

Real effective exchange rate (REER) = NEER ×

Wi = Trade weights of Korea’s major trade partners (United States, Japan, Germany, Great Britain); ei = Foreign exchange rates of won against U.S. dollar, Japanese yen, German Mark, and G.B. pound; Pi f = Wholesale or produce price indices of United States, Japan, Germany, and Great Britain; Pi = Korea’s producer price index Figure 6.4 Interest Rate (3-Year Corporate Bond Yield)

Source: Korea Institute of Finance. Note: Period average.

140

Two Crucial Problems

Figure 6.5 Interest Rate (3-Year Corporate Bond Yield)

Source: Korea Institute of Finance. Note: Period average.

Figure 6.6 Korean Stock Price Index

Source: Korea Institute of Finance. Note: Stock price index at end of period.

The Financial Crisis in Korea

141

Figure 6.7 Korean Stock Price Index

Source: Korea Institute of Finance. Note: Stock price index at end of period.

crisis, focusing on the process of financial liberalization and its effects on domestic investment. Lessons and implications of the crisis for reform of the international financial system are then analyzed. Buildup to the Crisis

Korea rebounded strongly from its slowdown in growth in 1992 and 1993. It did not experience the kind of double-digit growth that it had during the period of 1986–1989, but the economic growth from 1994 to the beginning of 1997 was almost 8 percent (on average) per annum. It peaked in 1996 at nearly 9 percent (see Tables 6.1 and 6.2). Like the earlier periods of high economic growth, the economy was once again being fueled by exports. What was different during the 1994– 1996 period was that the high growth was also spurred by high investment. In many respects, this investment was a positive development as the economy was coming out of a mild contraction during the 1992–1993 period, but it was also responsible for a sharp increase in the current-account deficit and the financial and foreign exchange crisis in which Korea finds itself today. Why exactly did Korean firms embark upon such an investment

142

Two Crucial Problems

spree? There were two major developments: the strengthening of the Japanese yen and the financial liberalization and market opening, which increased the availability of low-cost foreign credit. Financial Opening and Investment Boom

The 3-year period from the second half of 1992 to the first half to 1995 was witness to the “super” yen. Until the spring of 1995, when the yen hit the level of 79.5 to the dollar, there seemed to be no end to the yen’s rise. The appreciation of the yen brought about a sharp increase in the export earnings of East Asian countries as they were becoming increasingly competitive vis-à-vis Japan in exports of manufactures. This process, in turn, encouraged a great deal of investment throughout East Asia. Because it competed directly with Japan in many industries where Japan had been a predominant exporter, Korea benefited the most of all East Asian countries from the high-valued yen. During the third quarter of 1995, however, the yen reversed itself and began to decline, and since then the yen-dollar exchange rate has continued to depreciate. At about the same time, the terms of trade moved against Korea and continued to deteriorate for the next 2 years. The terms Table 6.1 Major Indicators of the Korean Economya (percentage) GDP (rate of growth) Consumption Fixed investment (construction) (equipment) Commodity exports Commodity imports Gross savings/GDP Gross investment/ GDP Increase in stocks/ GDP Current account/GDP Terms of trade (rate of change) Consumer price index (rate of change) Producer price index (rate of change)

1991

1992

38.9

36.6

9.1 9.3 12.6 13.0 12.1 12.2 19.4 35.9

5.1 6.8 –0.8 –0.6 –1.1 10.9 4.0 34.7

1993

1994

35.1

36.1

5.8 5.3 5.2 8.9 –0.1 9.7 5.6 35.1

8.6 7.0 11.8 4.5 23.6 14.6 21.8 35.2

0.5 –2.8

0.0 –1.3

–0.9 0.3

0.3 –1.0

9.3

6.3

4.8

6.2

0.6

4.7

0.0

2.2

4.4

1.5

1995

8.9 7.2 11.7 8.7 15.8 25.3 21.3 35.9

37.0

0.5 –1.8

1996

7.1 6.9 7.1 6.3 8.2 14.5 13.9 34.3

38.2

1.4 –4.8

1997

6.1 5.0 –2.1 0.9 –5.9 24.2 6.5 34.2

0.7 –1.8 –12.1 –6.1 –20.8 14.5 2.0 34.8

— –1.9

— 0.7

36.1

1.2

–3.6

–12.3

–10.3

2.8

4.7

2.7

3.8

4.5

4.9

1998b

4.4

34.1 —

10.1

21.1

Source: Bank of Korea, National Income, various issues; Bank of Korea, Balance of Payments, various issues; National Statistical Office, Consumer Price Index, various issues. Notes: a. Averages from the first quarter to the third quarter; b. Korea Institute of Finance forecasts.

–23.7 –15.3 128.3 (4.1) 143.6 (12.2) –7.6 –0.8 17.0

–7.4 –5.4 30.6 (–2.9) 36.0 (5.7) –1.8 –0.2 4.8

1st Quarter –2.8 –0.7 35.6 (9.3) 36.3 (1.7) –2.0 –0.1 5.8

2nd Quarter –2.1 0.0 34.6 (16.3) 34.6 (–2.0) –1.9 –0.2 1.5

3rd Quarter –0.7 0.0 12.1 (7.7) 12.1 (–7.0) –0.7 0.0 0.0

Oct.

1997

Source: The Bank of Korea, Balance of Payments, various issues. Note: a. Korean Institute of Finance forecasts; b. percent in billions U.S. dollars.

Current account Trade Exports (%)b Imports (%)b Invisible trade Transfers Capital account

1996

Table 6.2 Balance of Payments (billions of U.S. dollars; percentage)

0.5 0.7 12.1 (4.8) 11.4 (–11.0) –0.2 0.0 –2.0

Nov. 3.6 2.7 12.6 (7.5) 9.9 (–21.8) 0.2 0.8 —

Dec. 3.4 3.4 36.8 (6.7) 33.4 (–13.3) –0.7 0.8 —

4th Quarter

–8.9 –2.8 137.5 (7.2) 140.4 (–2.3) –6.3 0.3 —

Year

3.0 10.9 147.8 (7.4) 136.7 (–2.6) –8.6 0.8 —

1998a

144

Two Crucial Problems

of trade shock, which in part reflected the stagnation in demand for Korea’s major export products, worsened the current-account deficit and triggered a deceleration of the economy (see Figures 6.8 and 6.9). Despite these adverse developments, the Korean policymakers were not prepared to make any substantial adjustment in the won-dollar exchange rate. As a result, the real effective (trade-adjusted) exchange rate appreciated for more than a year from the third quarter of 1995 and thereafter remained relatively stable until November 1997, when the current financial crisis broke out. The reason for the Korean policymakers’ reluctance to devalue the won during this period was not altogether clear. It is speculated, however, that the policymakers, who were then preoccupied with industrial restructuring, believed that a strong won would help facilitate the shifting of resources away from those industries, such as light manufacturing, where Korea was losing its competitiveness. If this was indeed their policy objective, much of the effect of a strong won was more than offset by a large increase in foreign-capital inflows facilitated by the deregulation of capital-account transactions. This increase in foreign-capital inflows helped maintain a relatively strong won, but because the domestic interest rate was more than twice the level of interest rates in international financial markets, the strong currency could hardly deter Korean firms from expanding their investment.1 Between 1994 and 1996, net foreign-capital inflows amounted to $52.3 billion, more than three times the total net inflows for the 1990– 1993 period (see Table 6.3).2 Much of the inflows, which consisted of short-term liabilities of domestic financial institutions and firms, were then channeled to finance investment in Korea’s major export-oriented industries: electronics, automobiles, iron and steel, shipbuilding, and petrochemicals. As a result investment jumped to 38.2 percent of GDP in 1996 from about 35.0 percent 3 years earlier and resulted in a large increase in the current-account deficit, which reached almost 5 percent of GDP (see Table 6.1). Although the economy began to decelerate during the second half of 1996, largely due to the sharp decline in the prices of Korea’s major export products (including semiconductors), the large industrial groups or chaebols that dominate Korea’s manufacturing sector were unable or unwilling to adjust their production and investment. Their inventories piled up, but commercial banks were becoming less willing and more selective in extending credit to these groups because the banks were increasingly concerned about the groups’ growing losses and accumulating debts. Denied sufficient credit at commercial banks, the chaebols had to secure high-cost, short-term loans from merchant banks—and turned to foreign financial institutions and markets for financing fixed investment as well as inventories. The merchant banks expanded their investment not only in domestic industries, but also in foreign countries. In 1994, Korea’s total foreign

The Financial Crisis in Korea Figure 6.8 Savings/GDP, Investment/GDP, and Current Account/GDP

Source: Bank of Korea, National Income, various issues; Bank of Korea, Balance of Payments, various issues.

Figure 6.9 Terms of Trade and Current Account

Source: Bank of Korea, Balance of Payments, various issues.

145

146

Two Crucial Problems

investment rose to $2.3 billion from less than $1.3 billion a year earlier. Over the next 2 years, it grew 33 and 36 percent, respectively, and much of this investment went to Southeast Asia and Europe, and no doubt was financed by foreign credits. The available data are rather sketchy, but foreign debts of domestic firms amounted to $35.6 billion at the end of 1996. This figure jumped to $43.2 billion a year later. (Private foreign debts as defined by the Korean government do not include those liabilities of the foreign subsidiaries and branches of Korean firms, unless the payments of these debts are guaranteed by their parent firms.) The exact amount of these liabilities was not known, but it was estimated to be over $51 billion at the end of June 1997.3 Why were Korea’s industrial groups so inflexible and slow in adjusting their investment and output in response to the changes in the internal and external environment? The answer lies in some of the salient characteristics of the Korean chaebol, one of which was to compete for market share more than for profits. This feature was often attributed to the Japanese model of government-led economic development, but it was largely the consequence of a Korean industrial policy geared toward obtaining scale economies in major export industries at an early stage of development. All major chaebols were pursuing business in only the tried and proven industries, so profits were driven down, forcing them to carve out the largest market shares they possibly could and also diversify at the first opportunity into new industries that promised high profits. As a result, all the largest chaebols went on to expand their investment in Korea’s major industries so as not to lose their relative positions in the economy. Furthermore, the rigid and bureaucratic management system, in which the decisionmaking was concentrated at the top, made it difficult for the chaebols to adjust their investment and production to changes in market conditions as rapidly as they should have. Because practically all the chaebols were family owned, they were reluctant to issue equities because doing so could have diluted management control. These characteristics, together with the underdevelopment of the domestic capital markets, caused the chaebols to become highly leveraged. A recent survey shows that the average debt-equity ratio of the 30 largest chaebols was more than 380 percent in 1996, four times higher than that of Taiwanese firms. 4 As it turned out, the high leverage of the corporate sector proved to be the Korean economy’s greatest structural weakness. Much of the expansion in investment could be made possible only by taking on enormous amounts of debt, and the rapid debt accumulation by the chaebols meant that the economy as a whole became more susceptible to a slowdown in growth and a financial crisis. Because it was determined to rely more on the market for the management of the economy, the new government that came to power early in

–5.4 –4.4 (82.0) –3.5 (0.7) n.a. 0.0 0.9 0.2 –1.0 (18.0) –0.4 n.a. 0.0 0.5 0.4 0.6 0.0 0.2 0.1

5.2 3.4 (65.2) 3.9 0.7 1.7 1.1 0.5 1.1 1.8 (34.8) 4.4 2.2 0.5 0.5 0.4 2.6 0.1 1.8 0.0

1990 to 1993h

17.4 7.2 (41.6) 11.8 1.3 3.4 5.3 4.6 3.0 10.1 (58.4) 18.1 3.5 3.8 6.0 2.5 7.9 0.6 4.8 0.9

1994 to 1996h 11.6 4.1 (35.7) 6.4 0.8 3.3 2.0 2.2 2.1 7.4 (63.7) 13.8 2.5 2.7 4.1 2.5 6.4 0.5 4.1 0.2

1994 17.4 6.9 (39.4) 12.3 1.2 3.4 5.5 5.4 3.1 10.6 (60.1) 18.7 2.9 4.0 7.6 2.1 8.1 0.4 5.4 0.5

1995 23.2 10.7 (46.2) 16.9 2.0 3.7 8.5 7.1 3.9 12.5 (53.9) 21.8 5.1 4.8 6.3 2.9 9.3 0.9 5.0 2.0

1996 14.3 11.5 (81.0) 16.6 1.9 4.9 7.3 5.0 3.0 2.7 (19.0) 6.9 2.8 3.5 –1.1 3.0 3.2 1.2 1.4 0.4

January to October 1997

Source: “Capital Account Liberalization and the Structural Change of the Capital Account in Korea,” Monthly Bulletin, Bank of Korea (December, 1997). Notes: a. Domestic financial institutions include deposit-money banks, foreign bank branches in Korea, development institutions, and merchant banks. b. Portfolio investments in domestic securities by foreign investors. c. Includes short-term liabilities of merchant banks and development institutions and commercial paper and other short-term securities issued by depositmoney banks. d. Borrowings of foreign bank branches in Korea from their home offices. e. Portfolio investments in foreign securities by domestic investors. f. Changes in foreign-currency assets of overseas branches of domestic deposit-money banks. g. Changes in foreign-currency assets of overseas branches of domestic merchant banks and development institutions. h. Annual average of the period.

Total capital-account balance (A) Long-term capital balance (B = C–D) (B/A, %) Inflow (C) (Foreign direct investments) (Foreign securities issued by firms) (Foreign securities issued by finanical institutions)a Outflow (D) (Overseas direct investments) Short-term capital balance (E = F–G) (E/A, %) Inflow (F) (Portfolio investments)b (Short-term trade credit) (Short-term borrowings of financial institutions)c (Interoffice accounts)d Outflow (G) (Portfolio investments)e (Assets of deposit-money banks)f (Assets of merchant banks and development institutions)g

1986 to 1989h

Table 6.3 Long-term and Short-term Capital and Financial Accounts Transactions (billions of U.S. dollars, percentage)

148

Two Crucial Problems

1993 mounted a campaign of market deregulation and opening. The WTO agreement did not leave much room for industrial policy, and market liberalization took away what was left of the government’s control of the production and investment activities of the large conglomerates and enterprises. The deregulation efforts succeeded in freeing the chaebols from the government but did not institute mechanisms to monitor and control the chaebols’ management. Furthermore, small stockholders had never had much voice in the management of the chaebols. So, with the government no longer able to control or coordinate the investment activities of the chaebols, they were free to do whatever they believed was in their best interests. Financial Deregulation with Inadequate Supervision

From the 1960s through the 1980s, capital-account transactions had been tightly regulated. Many restrictions on capital movements in and out of the country were put in place to facilitate the government’s industrial policy and to minimize the destabilizing effects of short-term capital flows on the economy. All of this began to change in the early 1990s. By this time, the effectiveness and viability of Korea’s interventionist regime had come into question due to the increasing complexity of the economy. Korea had also come under increasing pressure from developed countries, led by the United States, to liberalize its financial sector, so Korea found itself beset by necessity to pursue liberalization from both within and without. Financial market deregulation and market opening began in earnest in 1993, immediately after the inauguration of the current administration, and it was accelerated by Korea’s accession to the OECD as its 29th member. Fewer than 7 years have elapsed since then, but the Korean experience demonstrates, as have many other cases of financial market opening, that unless such opening is properly managed in emerging market economies with adequate supervision it can easily lead to a boom-and-bust cycle during the transition period. Although the market deregulation and opening in Korea was carried out in a gradual and piecemeal manner, it led to a surge in foreign-capital inflows during the 1994–1997 period, many of which were short-term and speculative. With the acceleration in financial liberalization, domestic financial institutions were allowed greater freedom in managing their assets and liabilities, in particular in borrowing from international financial markets. The greater freedom, together with the moral hazard inherent in the Korean financial system, also weakened the financial institutions’ discipline in lending, in particular to large industrial groups, and in managing market risk. In fact, these institutions took much greater risks in their investment in foreign securities with borrowed short-term funds than prudent management would have permitted, thereby exposing them to the problem

The Financial Crisis in Korea

149

of balance sheet mismatch. These developments made the Korean economy highly vulnerable to the speculative currency attack and liquidity crisis. In retrospect, Korean financial institutions were not adequately prepared for a financial market opening because they had not developed expertise in credit analysis, risk management, and due diligence. They had had little experience in foreign exchange and securities trading and international banking in general. The supervisory authorities did not monitor and regulate their international financial activities as much as they should have; they were pressured to overhaul the regulatory system to make it more compatible with a liberalized system. The authorities eliminated and relaxed many restrictions and control measures, but failed to install in their place a new system of prudential regulation needed to safeguard the stability and soundness of financial institutions. During the 3-year period from 1994 to 1996, total capital flows (inflows plus outflows) rose to more than 47 percent of GDP from less than 30 percent during the preceding 3-year period (see Table 6.4). Net inflows during the same period, which amounted to $52.2 billion—and unlike in the 1980s the bulk of these inflows consisted of short-term borrowings with maturities less than 1 year—accounted for 58.4 percent total net inflows, compared with 34.8 percent during the 1990–1993 period (see Table 6.3). Short-term capital inflows include foreigners’ portfolio investment (mostly equity investment), trade credit, short-term borrowings by banks and other financial institutions, and borrowings by Korean branches of foreign banks from their headquarters. The aggregate as well as individual ceiling on foreigners’ investment in equities has been raised gradually since 1992. This relaxation, together with the favorable prospects of the Korean economy, induced a surge in foreigners’ equity investment during the 1994–1996 period. However, compared with other forms of short-term capital inflows, the amount of portfolio investment was modest. The inflow in the form of trade credit jumped more than sevenfold, bank borrowing elevenfold, and borrowing by Korean branches of foreign banks from their home offices more than sevenfold between the two subperiods. There were several reasons for the large increase in short-term capital inflows. One reason was the rapid growth in trade volume, which required an equal increase in imports, and export-related credits. However, the growth in short-term capital inflows outpaced the expansion in trade. This discrepancy is explained by the use of trade credit facilities as the routes of capital inflow that were, in turn, induced by the high interest rate differentials between the domestic and foreign financial markets in the context of stable foreign exchange rates. Deregulation of trade credits led to a lengthening of the periods of deferred and installment payments for imports ranging from 6 months to 3 years. Exporters were also allowed to offer suppliers’ credits to foreign importers with longer maturities ranging from 1 to 2 years. The ceilings on export advances and export downpayments

188.6 (24.7) 169.0 (19.9) 357.7 (22.0) (29.8) 20.9 –15.0

1990–1993 342.3 (33.4) 290.1 (28.1) 632.5 (30.9) (47.3) 52.2 –37.2

1994–1996 82.8 (37.4) 71.1 (24.9) 153.9 (31.4) (40.4) 11.6 –4.5

1994 117.4 (41.8) 100.1 (40.7) 217.5 (41.3) (47.6) 17.4 –8.9

1995

142.1 (21.0) 118.9 (18.8) 261.0 (20.0) (53.9) 23.2 –23.7

1996

119.2 (4.2) 104.9 (10.0) 22.4 (6.8) — 14.3 –13.2

January to October 1997

Source: “Capital Account Liberalization and the Structural Change of the Capital Account in Korea,” Monthly Bulletin, Bank of Korea (December 1997). Notes: a. Average annual growth rate; b. capital-account balance is different from total capital inflow (A) minus total capital outflow (B) because of the statistical errors resulting from reclassifying the capital-account balance.

87.1 (3.8) 108.4 (9.1) 195.5 (6.0) (31.8) –21.5 33.7

1986–1989

Capital and Financial Accounts of Korea (billions of U.S. dollars, percentage)

Total capital inflow (A) (growth rate)a Total capital outflow (B) (growth rate)a Total capital transactions (A+B) (growth rate)a ([A+B]/GDP) Capital-account balanceb Current-account balance

Table 6.4

The Financial Crisis in Korea

151

were also raised. These changes contributed to a large increase in trade credit. Commercial banks, for their part, had to increase their foreigncurrency borrowings to accommodate the growing demand for export and import financing, that is, to purchase the growing volume of export bills and finance imports on credit. There was another reason for the surge in short-term bank borrowing. Beginning in 1994 the ceiling on foreign-currency loans by commercial banks was lifted, but the ceiling on commercial banks’ medium- and longterm borrowing from the international financial market was not eased. As a result commercial banks were forced to raise short-term credits to finance long-term loans at home. Commercial banks were also attracted to short-term financing because the costs of short-term borrowing were lower than those for issuing medium- and long-term securities, largely because these banks had not established sufficiently high credit ratings to borrow from the long-term capital markets. The external liabilities of commercial banks consisted mostly of traderelated refinance, bank loans, and securities issued, including commercial paper. Although commercial banks traditionally borrowed at the short end of the financial market and extended short-term loans, the rise in their short-term indebtedness was alarming; the share of the short-term in total external liabilities jumped to 79 percent in 1994 from less than 65 percent a year earlier (see Tables 6.5 and 6.6).5 Much of the increase came from the issuance of commercial paper. Over the next 2 years, the share of short-term liabilities remained well over 70 percent, but instead of issuing commercial paper commercial banks were relying on credit lines and loans for subloans and other short-term loans as the major sources of short-term foreign credit. Although precise data and reliable information are not available, the commerical banks were likely making long-term foreigncurrency loans to their customers with lending resources secured from the short-term money market, thereby creating a mismatch problem. In retrospect, the mismatch problem made the management of the financial crisis much more difficult. Why did the Korean policymakers let banks and other financial institutions borrow so much from the short-term money markets? Why did they not open the domestic bond market and liberalize long-term external financing? Perhaps the policymakers ignored the management of short-term liabilities because these liabilities do not add to the stock of foreign debts since they mature and are paid off within a year, whereas long-term liabilities do. The Korean authorities have not regulated short-term external credit transactions of banks and the financial institutions because these transactions are tied to the international financial services they provide. They may have overlooked the possibilities that short-term loans could not be rolled over continuously and that short-term credit facilities could be abused as means of financing long-term investment.

7,220 4,813 68 399 4,346 3,818 528 2,407 1,470 666 138 133

(100) (66.7) (1.0) (5.5) (60.2) (52.9) (7.3) (33.3) (20.4) (9.2) (1.9) (1.8)

6,554 4,222 92 467 3,663 3,210 453 2,332 1,503 572 119 138

(100) (64.4) (1.4) (7.1) (55.9) (49.0) (6.9) (35.6) (23.0) (8.7) (1.8) (2.1)

1993 10,941 8,077 80 1,062 7,493 6,935 558 2,306 1,159 778 220 149

1994 (100) (78.9) (0.7) (9.7) (68.5) (63.4) (5.1) (21.1) (10.6) (7.1) (2.0) (1.4)

18,942 14,642 127 1,581 12,934 10,177 2,757 4,300 1,129 2,872 115 184

1995 (100) (77.3) (0.7) (0.8) (68.3) (53.7) (14.6) (22.7) (6.0) (15.2) (0.6) (1.0)

26,708 19,582 177 2,026 17,379 11,295 6,084 7,126 758 6,141 57 170

1996

(100) (73.3) (0.7) (7.6) (65.1) (42.3) (22.8) (26.7) (2.8) (23.0) (0.2) (0.6)

Source: Bank of Korea, Foreign Exchange Statistics, various issues. Notes: a. The figures in parentheses are percentages of total external liabilities; b. The external liabilities due to banks include credit lines from the foreign banks and borrowings for subloans; c. Other borrowings include commercial paper, CDs, and other short-term securities issued by the depositmoney banks.

External liabilities Short-term liabilities Deposits Call money Borrowings from banks (due to banks)b (other borrowings)c Long-term liabilities Borrowings from banks Foreign securities issued Interoffice accounts Others

1992

Table 6.5 External Liabilities of Domestic Deposit-Money Banks in Koreaa (end of period, millions of U.S. dollars, percentage)

1,774 606 28 5 573 1,168 730 437 1.0

(100) (34.2) (1.6) (0.3) (32.3) (65.8) (41.2) (24.6) (0.1)

1,450 303 19 1 283 1,147 727 419 1.0

(100) (20.9) (1.4) (7.1) (55.9) (79.1) (50.1) (28.9) (0.1)

1993

Source: Bank of Korea, Foreign Exchange Statistics, various issues. Note: The figures in parentheses are percentages of total external liabilities.

External liabilities Short-term liabilities Deposits Call money Borrowings from banks Long-term liabilities Borrowings from banks Foreign securities issued Others

1992

Table 6.6 External Liabilities of Merchant Banks in Korea (end of period, millions of U.S. dollars, percentage) 1,820 654 0 46 608 1,166 491 674 1

1994 (100) (35.9) (0.0) (2.5) (33.4) (64.1) (27.0) (37.0) (0.1)

3,872 1,966 0 56 1,910 1,906 435 1,470 1

1995 (100) (50.7) (0.0) (1.5) (49.3) (49.2) (11.2) (38.0) (0.0)

5,942 3,190 0 58 3,132 2,752 327 2,388 37

1996

(100) (53.7) (0.0) (1.0) (52.7) (46.3) (5.5) (40.2) (0.6)

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Although the deterioration in the quality of assets and the prevalence of short-term external financing were clearly visible, the supervisory authorities did not order the financial institutions to take corrective measures. They did not do so because, nurtured in the old tradition of direct control and bank examination, they had neither the resources nor experience in monitoring and regulating the overall soundness and profitability of financial institutions. Long relegated to the role of supporting manufacturing industries under the control of government, banks and other financial institutions had become accustomed to accommodating much of the credit needs of the industrial conglomerates without necessarily checking their creditworthiness. In fact, many commercial banks were competing among themselves to win over these chaebols because the latter were regarded as prime customers with little credit risk. As in Japan, Korean banks also consider it important to establish longterm relationships with their customers by serving as their main banks. This device is often alleged to be an efficient means of collecting information and dealing with the information asymmetry problem. However, the long-term relationship could be counterproductive in that banks often find it difficult to keep their long-term customers at arm’s length, in particular if their customers are powerful chaebols. During the 1994–1996 period, it appears that banks failed to deal prudently with these conglomerates, acting more as if they were in an implicit partnership, and so were not able to curb their excessive investment. This relationship banking also explains why the banks were taken by surprise when their foreign customers and creditors severed ties with them as the financial crisis unfolded. The banks had never expected the foreigners to cut them off. A search for clues to the ongoing financial crisis in recent periods has led to the auditing and examination of the asset and liability management of financial institutions, including commercial banks. A preliminary report of the examination is alarming, revealing how reckless these institutions were in investing in foreign securities, engaging in the operation of offshore funds, and dealing in financial derivative products. According to a recent report by the Securities Supervisory Board, Korean securities firms and investment trust companies incurred heavy losses in their operations of offshore funds established in Malaysia, Ireland, and France in recent years. At the end of 1997, the total losses amounted to about $1.1 billion. Twentyeight Korean securities firms established 89 offshore funds and leveraged them two to five times the capital base. Of the total investment of $2.6 billion, $1.1 billion was the firms’ own capital, and the remainder consisted of borrowings from foreign sources. Disguised as foreign institutional investors, they invested heavily in Korean stocks and high-risk securities issued by firms and financial institutions in Southeast Asia. Other revelations show how inept and inexperienced Korean financial institutions were in investing in financial derivatives. Their investments became total losses.

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According to a recent newspaper report, Korean merchant banking corporations, which have been permitted to engage in international finance in recent years, had borrowed $20 billion from the short end of the international financial market by the end of October 1997. Not surprisingly, they had invested their funds in highly risky securities issued by firms in Southeast Asian countries. About 5 percent of their investments in October were classified as nonperforming assets. Lessons and Reform of the International Financial System

The financial crisis in Korea has demonstrated that both domestic borrowers and foreign lenders are clearly to blame for bringing on the crisis, and that the IMF has not been as effective as hoped in restoring stability. Borrowers—usually taking the lion’s share of the blame for crises—with their disregard for prudence and ignorance of risk management, especially with regard to exchange rate risk, need to be controlled in some way. Lenders need to be curbed as well. With little else driving them but short-termprofit considerations and the herd mentality, the lenders were able to disrupt an economy in a catastrophic way as they withdraw their investments and exited at the first sign of serious danger. These investor characteristics may call for international regulatory mechanisms to be put into place; and in an increasingly integrated world economy better means for managing crises once they erupt need to be worked out, although any reform of the international financial system at this stage would be difficult indeed. Overshooting and Moral Hazard

Why has the Korean crisis been so severe in the absence of a large economic shock and any measurable deterioration in economic fundamentals? What developments triggered the crisis? According to Eichengreen and Wyplosz there are three types of distortions that could give rise to a financial crisis.6 One type of distortion is asymmetric information and the herd behavior on the part of foreign investors and financial institutions. Another is moral hazard in both the domestic and international financial systems. The third is any distortion, including a political one, that could lead to multiple equilibriums in the foreign exchange market. All these distortions were present in Korea. Incompletely informed investors display, successively, excessive optimism and then excessive pessimism. Investors follow the lead of other investors, committing funds to markets with good prospects like the East Asian markets. Bad news or simply a change of sentiment often provokes a violent reaction. The financial crisis in Korea may have been triggered by the contagion of the Southeast Asian crisis and, in particular, the speculative attack on the Hong Kong dollar. After

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what took place in Hong Kong, the Korean economy suddenly looked vulnerable in the eyes of many foreign investors. A stampede of frightened investors then followed. The “moral hazard problem” and the close presidential race, which cast doubt on the prospects for economic reform, accelerated the flight of foreign investors in panic. In the end, the expectative change caused by the contagion of the Southeast Asian crisis shifted Korea from a relatively stable to a bank run equilibrium. As shown in Tables 6.3 and 6.5, securitized capital has accounted for more than 70 percent of the capital inflows into Korea since the early 1990s.7 The predominance of portfolio investment has made global institutional investors much more important in international finance. Since they are driven largely by liquidity and short-term performance considerations, portfolio capital inflows are obviously far more volatile than bank loans because portfolio capital can leave a country in just a few hours whereas medium-term bank loans cannot. The growing importance of portfolio capital has made the contagion of a financial crisis more likely, as has been the case in East Asia, and has also deepened, and complicated the management of, the ongoing crisis in Korea. As noted above, foreign equity investors began to withdraw their investments from the Korean stock market as early as the first week of September. Taking their cue from these portfolio investors, foreign banks soon started to refuse to rollover their short-term loans to Korean financial institutions; that is, financial market opening, together with the predominance of portfolio capital inflows, has permitted and actually given rise to sudden capital outflows, resulting in inordinate increases in interest rates and excessive depreciation of the foreign exchange rate. The Korean crisis has been further exacerbated by the “moral hazard problem” in the Korean banking system and in the IMF program. As is widely known, commercial banks and merchant banking corporations have long operated with implicit government guarantees in Korea. Although a deposit insurance system is in place, few believe that the government could allow these institutions to go bankrupt. This guarantee, together with inadequate regulation, provides an incentive to banks to borrow larger amounts of funds abroad for domestic lending than they would otherwise and to invest in riskier projects in the expectation that the government will bail them out in the event they incur serious losses. This moral hazard appears to have affected the behavior of foreign financial institutions lending to Korean banks and other financial institutions as well. Since the foreign institutions should, and expect to, receive national treatment, they also believe that, like domestic depositors, the payment of principal and interest on their loans is guaranteed by the government, although there is no formal guarantee to that effect. They also know that as a group they could put pressure on the Korean government to come forward with the promise of guarantee by threatening a financial and

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currency crisis by withdrawing their loans from Korea. Indeed, when some signs of a financial crisis began to appear this is precisely what they did, and very successfully at that. Because of the implicit guarantee, foreign banks did not feel the need to conduct careful credit analyses of the Korean financial institutions to which they were lending vast sums. When some of the symptoms of the crisis began to surface few foreign banks were trying to reschedule their loans to troubled Korean banks, in sharp contrast to what they normally would have done if dealing with delinquent borrowers at their home bases. Information on Korea’s corporate sector and financial institutions, including the intelligence that most of the published corporate and banking data were unreliable, was available. This problem of faulty information is to a significant extent rooted in the foreigners’ lending behavior: based on the moral hazard issue foreign investors did not even try to gather and analyze the available information. Another type of “moral hazard” also arose during the Korean financial crisis. Once it became clear that Korea could not overcome its impending financial crisis, which was in part precipitated by their fund withdrawal, international banks and institutional investors began putting pressure on the Korean government to seek IMF financing. They did this because a debt moratorium would not be an efficient or realistic mechanism of debt resolution for the simple reason that there were too many investors and too many types of investors. Negotiations would not have been feasible. More important, the IMF program favors creditors more than debtors. The fact that the IMF has come to Korea’s aid means that the foreign banks will be able to recover their investments with relative ease, and perhaps even profit, because the austere monetary and fiscal policies that the IMF is requiring of Korea mean extraordinarily high interest rates. However, the agreement between the Korean government and the IMF on the structural reform and rescue package was not sufficient to satisfy the foreign banks and, as a result, did little to change the markets’ sentiment, at least during December. This is because foreign banks, in view of what was happening in Indonesia and Thailand, were not sure whether the IMF could enforce the implementation of financial- and real-sector reforms during a political transition period marked by an inept lame-duck government, which would remain in power until the end of February 1998, and great uncertainties surrounding the presidential election held on 18 December 1997. In addition to the Korean government’s compliance with the IMF program, foreign lenders wanted to be assured of the payments of the principal and interest on their loans; otherwise, they would not return to the Korean market.8 These lenders have asked for and received the provision of a government guarantee on private debt on the grounds that it would facilitate and simplify the negotiations on the debt restructuring and the supply of new credit with Korean financial institutions.

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Toward the end of January, international creditor banks agreed to convert most ($24 billion) of the short-term currency debt of Korean banks into long-term loans with government guarantees that mature over 1 to 3 years. The new loans will have variable interest rates of between 2.25 and 2.75 percentage points above Libor. The new loans will be in the form of transferable loan certificates. Although the premium for the governmentbacked loans is high and will keep the domestic interest rates high, the loan deal is widely regarded as favorable to Korea. In the case of Indonesia, foreign banks and institutional investors are also demanding government guarantees on the payment of principle interest on corporate debt, and they may succeed. Now that the seriousness of these underlying problems is obvious, we have to ask whether global institutional investors and international commercial banks whose activities cross national borders should be monitored and subject to some types of regulations. At present, capital flows originating from global institutional investors are completely unregulated in their source country, and even less so internationally. They certainly have not been regulated in Korea. Griffith-Jones advocates the creation of an international supervisory mechanism to which the task of regulating shortterm capital flows could be assigned.9 There is controversy over whether such a global governance mechanism would be effective in stabilizing short-term capital movements. And assuming it would be, which countries or institutions should be responsible for the task? How should the different financial rules and enforcement mechanisms of different countries be coordinated and made uniform? Should the system be made uniform globally or at a regional level? A global system would of course face opposition and would be difficult to negotiate in the near term. However, since the European Union members have agreed to common rules and supervision, it seems reasonable to ask whether other countries in different regions should attempt to establish regional frameworks for financial regulation and supervision. This issue merits further discussion because smaller groups of countries where institutions are similar would naturally face far fewer hurdles on the way to establishing viable international arrangements. Certain public goods are better provided through such arrangements, and financial regulation would certainly seem to be one of them.10 Prevention and Better Management of Financial Crises

Another important question to be raised at this point in the ongoing East Asian currency turmoil is whether the crisis could have been prevented and been better managed once it erupted. It is discouraging that despite the best efforts of the participants of the G-7 Halifax Summit to work out effective means of prevention and management of currency crises, financial

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turmoil began to rock Southeast Asia in the summer of 1997 and spread to other countries. Korea has been claimed as the latest casualty, with speculation that there could even be others later on. Griffith-Jones makes a number of suggestions for crisis prevention, which include (1) better management of macroeconomic policies, (2) fuller disclosure of information to market participants, (3) establishment of an early warning system with improved monitoring of national economic policies, and (4) regulatory restrictions on capital flows to emerging markets both by creditors and debtor countries.11 Following these suggestions, there was little Korea could do alone to protect itself from a crisis except for making more and reliable information available. Kindleberger’s study on the causes, characteristics, and propagation of financial panics and crashes in a historical perspective leaves us little doubt that financial crises will continue to recur so long as banks and investors with propensities for speculative excess cause domestic bank runs.12 Likewise, there will always be national economies that mismanage their financial industries and macroeconomic policies, thereby inviting banking and foreign exchange crises. Since financial crises can occur for a number of reasons, it is not clear whether the symptoms of crises could be detected and identified beforehand. When the causes of financial crises in individual countries are domestic in origin, individual governments should be held responsible for resolving the crises. However, in an increasingly globalized world economy, the effects of a financial crisis are easily and rapidly transmitted to other countries, and this contagion, which often draws even healthy economies into financial turmoil, must be prevented. The efforts of the international community should focus on the prevention of financial contagion, not financial crises in individual countries. Could the Korean crisis have been prevented? In hindsight, the answer to this question is an unequivocal yes because Korea would not have been thrown into turmoil had the Southeast Asian crisis been contained where it occurred. Could the Korean crisis have been better managed? This is a more difficult question to answer since at the time of this writing not even 3 months have elapsed since the collapse of the foreign exchange market in late November 1997. However, the management of the Korean crisis as organized and supervised by the IMF reveals a classic dilemma of an international lender of last resort. If the IMF had the power of global lender of last resort and let it be known that it was prepared to supply an unlimited amount of credit until all capital outflows stopped, as central banks do when they encounter domestic bank runs, it would be reasonable to argue that the Korean crisis would have been short-lived. The IMF has neither the mandate as an international lender of last resort nor the resources to play such a role. The Korean experience also suggests that the presence of a powerful international lender of last resort would exacerbate the moral hazard problem. Knowing that the rescue is forthcoming, the markets will lose the

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incentive to resolve the crises by themselves. Neither the initial rescue package agreed upon between the IMF and the Korean government nor the rescue funding was able to reverse the markets’ excessive pessimism. What was so surprising and unexpected about the Korean crisis was the markets’ lack of confidence in the IMF rescue efforts. The IMF funding package, though it was the largest in its history, did not impress the markets as much as it could have under different circumstances. Only when the G-7 countries produced additional financing of $8 billion and pleaded with the market participants to return to the Korean market, even threatening not to disburse additional commitments, did the withdrawal from Korea stop. It was as if the international financial community wanted to test whether the G-7 countries would honor their Halifax commitment. If this was what the markets are after, it is also not surprising that, as was the case in the Mexican crisis, a large share of the costs and strains are likely to be borne by the Korean economy and by the institutions of international support. As evidenced by the debt negotiations between the creditor banks and the Korean government, foreign banks are not going to share the costs of crises as much as they should. Quite to the contrary, it appears foreign banks are determined to reap a profit from the crisis, knowing that their market power will in the end force the public sector to accept their terms for the resumption of lending. The market power that international banks and global institutional investors hold is understandably difficult to confront. When it is combined with moral hazard, and when the IMF and G-7 will in the end serve, as they have, as lenders of last resort, the management of crises such as that in Korea becomes extremely difficult. Should there be a lender of last resort in international finance? And how should this lender, if it is established, mobilize its resources for intervention? In view of the systemic risk posed by the contagion of the East Asian crisis, could one make a strong case for creating a lender of last resort, disagreement over its precise role aside? To answer this question, it is instructive to examine the effectiveness of the IMF’s intervention in the Asian crisis so far. Although the IMF was not created to deal with systemic risk or to act as a lender of last resort, it has played such a role during the East Asian crisis simply because no other institutional arrangement capable of containing crises has ever been established and because the IMF offers a framework for collective support in times of individual countries’ crises.13 How effective has the IMF’s intervention been so far? It is too early to judge because at the time of this writing the crisis is still unfolding before us, but the Korean experience suggests that it has not worked as well as was perhaps expected. One can point to a number of reasons for the ineffectiveness of the IMF’s signal role. One is that the IMF does not come in to rescue a country until after the collapse of the foreign exchange market, not before. By the time that

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the IMF and the Korean government had agreed to a rescue plan the crisis had gathered force and was already at its peak; the IMF intervention was too late, and its financing package was not large enough to turn the tide. If indeed the IMF is going to serve as lender of last resort, the Korean experience shows that it would have to intervene at an early stage of a speculative attack. The problem here, however, is that governments in distress are extremely reluctant to ask for IMF assistance. Such a request is tantamount to admitting policy failure and is therefore a major political risk and embarrassment. In most cases when governments do finally decide to accept an IMF program, the succeeding negotiations usually drag on, wasting precious time while the markets are looking for decisive action. Had new IMF credit been injected earlier when clear warning signs of crisis were visible in Korea, the IMF program could have worked better. To play the role of lender of last resort, there should be a mechanism or institutional arrangement by which the IMF could intervene automatically to nip speculative attacks in the bud. Waiting for governments to ask for help on their own will almost always mean waiting too long. In this regard, a proposal has been made to create a new short-term financing facility at the IMF from which the member countries could borrow before a crisis erupts with the condition that they accept an IMF shadow program for approval.14 The idea of attaching policy conditionality before the crisis breaks out is meant to avoid the moral hazard dilemma—countries mismanaging their economy with the expectation that they would be rescued in case the markets panic. Although one would ask what country would mismanage their economy because the IMF stands ready to bail them out, the more serious problem lies with international banks and global institutional investors that would lend more money to these countries than they would otherwise, knowing that they could be bailed out. The IMF has little power to regulate banks’ and investors’ lending, and this lack of supervisory authority will likely weaken the effectiveness of the short-term financing facility because it leaves the IMF powerless to deal with moral hazard. The new automatic financing facility, to be effective and to avoid moral hazard, should include measures for regulating and supervising foreign investors as much as the member countries requesting the right for an automatic withdrawal. If controlling capital inflows at their source is not realistic, then the new facility should allow the member countries willing to accept the shadow program to institute a system of prudential regulations on capital-account transactions. Another reason why there were serious questions about the efficacy of the IMF program in Korea was that the program was not flexible enough to account for the unique characteristics of specific countries. The IMF is often criticized for applying the same program to all countries, as it has in

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the East Asian crises. Requiring tight fiscal and monetary prescriptions, for example, of a country with neither a fiscal deficit nor an inflation problem has been controversial. The controversy may also have dampened the IMF’s efforts to shift the markets’ sentiments. Admittedly, many of these industrial and financial reforms are much overdue in Korea, but it is not at all clear that they could not have been carried out without the IMF’s intervention. Indeed, it is difficult to judge whether the harsh monetary and fiscal tightening the IMF is requiring of Korea is necessary or even in the interests of Korea or the foreign investors. There is obviously a trade-off between (1) a relatively low domestic-market interest rate with a larger currency depreciation and with greater exchange rate volatility and (2) a high interest rate with a smaller depreciation and relative stability of the exchange rate. However, in an economy where firms are highly leveraged, as they are in Korea, a high-interest-rate policy could result in a high frequency of business failures—so high, in fact, that it could dislocate the industrial base itself, thereby undermining the economy’s debt-servicing capability. The won-dollar exchange rate changes have also been too volatile, often moving by more than 5 percent daily in either direction. This naturally raises the question of whether or not a lowering of the domestic interest rate would increase the exchange rate volatility: the monetary easing may help change the markets’ sentiment because it could improve Korea’s debt-servicing capacity in the medium term. The question is essentially empirical. A third reason why the IMF’s intervention may have been weakened is that the standard IMF program, which puts more emphasis on the development of economic policy reforms than on financing, may be less effective in cases where the creditors involved comprise a huge and faceless mass of parties, each of which has a different interest and outlook. It is time to ask whether these international banks and global institutional investors moving vast sums of money across national borders do actually understand the policy package and take it into consideration in their investment decisions. The difficulty with the IMF approach is that foreign investors in most cases may not have the capacity to determine whether the policy package will work. And even if they did, they may not have the patience to examine the thrust, objectives, and effects of the policy package. Since policy changes and structural reforms are subject to many uncertainties, international banks and global institutional investors could not afford to rely on a policy package that is claimed to cure the economic ills of a country far away from their bases, particularly when they are preoccupied with the short-term performances of their portfolios. The East Asian currency crisis, in particular that of Korea, leaves little doubt that the prevention of contagion of financial crises would be greatly facilitated if there existed an effective international lender of last

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resort, although the presence of such an institution in the future is highly unlikely. Kindleberger argues that although the moral hazard problem could be severe, there should be an international agency that has de jure responsibility for providing the public good of financial stability. He argues that to minimize the consequences of moral hazard, the efficiency of such an institution should be in doubt so that such an agency could “leave it uncertain whether rescue will arrive in time or at all so as to instill caution in other speculators, banks, cities, or countries.”15 Despite the inherent problems, many small open economies like Korea’s may have no alternative but to return to more restrictive capitalaccount regimes to safeguard themselves against the contagion of financial crises in the absence of mechanisms of multilateral cooperation, including a facility that serves as a lender of last resort regardless of whether or not such regimes would be effective and efficient. In the case of Korea, practically all of its foreign debt consists of private foreign liabilities of financial institutions and corporations. Except for the consideration of systemic risk, neither the domestic authorities nor the international lender of last resort should socialize these liabilities. One possible means of solving the moral hazard problem, which has been discussed extensively in the domestic context, would be a private insurance scheme for financial institutions. For a commitment fee, domestic financial institutions in emerging markets could receive standby credit from major international money center banks or other willing institutions to be drawn in the event of such emergencies as a bank run. Foreign investors and depositors might be much less inclined to withdraw their funds from specific financial institutions or from entire countries if this kind of insurance was a standard feature of international finance. Perhaps of equal importance, this system also has the merit of shifting the cost of financial bailouts from the public sector to where it belongs, the private sector, thereby further reinforcing the incentive for financial institutions to borrow and lend more wisely. This ultimately means that there would be more accountability at financial institutions and that there would be less possibility of taxpayers (in countries where crises have occurred and in countries that have extended emergency loans) having to mop up financial messes such as in East Asia today. Financial Liberalization in Emerging Market Economies

Three of the conditionalities required of Korea by the IMF are to all at once completely open the domestic financial services market, scrap the present foreign exchange control system (something that would partly entail deregulation of capital movements), and adopt a free-floating exchange rate system. These are regulatory changes that ordinarily occur over an entire generation in most countries. Important questions are whether these

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reforms would be consistent with each other if carried out simultaneously and whether they will contribute to the stability and efficiency of the domestic financial system. The Korean experience casts doubt on both the rationale and effectiveness of these changes. How should developing countries manage their integration into the global system? In view of the recent financial crises in East Asia, it would seem that they should be very cautious in opening their money and capital markets. Market opening greatly increases the countries’ exposure to speculative capital movements, which have been found to give rise to speculative bubbles and to dramatically destabilize local economies. Should developing countries delay integration until they can institute regulatory and supervisory systems that are comparable with those of advanced countries in terms of standardization and effectiveness? Or should they liberalize their financial systems in a big-bang style in the expectation that market forces will in the end stabilize capital movements? In recent years, Western governments have devoted increasing attention to securing the rights of access for their financial firms to the markets of developing economies. However, although these governments know that the accounting practices and disclosure requirements in developing countries do not conform to Western standards and that the supervisory financial authorities do not enforce rules and regulation as tightly as they should, few Western governments have demanded necessary financial reforms and changes. Yet they have been persistent in their demands for equal access and outright opening of domestic capital markets.16 Advanced countries have also not made clear their position on whose rules should apply to firms and financial institutions in developing countries or which nations or regulatory bodies should enforce these rules. As a result, the financial activities of international financial institutions, especially global institutional investors that regularly move vast amounts of capital across national borders, are not subject to prudential regulations and, understandably, are not scrutinized by regulatory bodies of either home or recipient countries. In the process of financial liberalization in many developing countries, the domestic regulatory and supervisory authorities are required to abolish those regulations that hinder the free functioning of the markets. In many cases, this is necessary because government intervention proves more of a hindrance than a help after an economy matures. However, all too often the useful prudent regulations are swept away as well—a classic case of throwing the baby out with the bath water. This has serious ramifications. Many institutions and firms in developing countries are inadequately supervised before deregulation occurs, so they are suddenly permitted to engage in all manner of financial activities in which they have neither experience nor competitive advantage. Because they will nevertheless make forays into international lending and borrowing

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and other such businesses, excessive deregulation more often than not sets up an economy for a major crisis. Needless to say, the Korean supervisory institutions had no authority to monitor the activities of those foreign financial institutions that had been lending all this money to Korean firms and financial institutions, let alone regulate them. Every country regulates and supervises its own domestic financial institutions and markets for a number of reasons, the most important being the lessening of systemic risk. In the transition from a controlled to a liberalized financial system, the regulatory and supervisory system is often weakened and not yet harmonized with the respective systems of other countries. Furthermore, except for the IMF, there is no lender of last resort that could support central banks in case foreign financial institutions call in or refuse to roll over their short-term loans to domestic financial institutions, thereby precipitating a crisis. This puts developing countries at a serious disadvantage and in very real danger, and it does not serve the interests of the international financial community to force developing countries to open up their financial markets without providing public goods that will safeguard these countries from currency crises and other systemic risk. In a small economy like Korea’s, which is also now financially open (since December 1997), internal and external shocks to the domestic markets are instantaneously transmitted to the foreign exchange market. Especially when the foreign exchange market is thin and forward arrangements are not readily available, the spot exchange rate reacts sharply to domestic and foreign shocks, leading to substantial changes in the real exchange rate by the day—and sometimes by the hour. This kind of exchange rate instability can be disruptive to production and investment in an economy open to international trade. A fundamental question is whether such an economy fully integrated with the global financial system can maintain a flexible exchange rate system. Korea has experimented with both a managed floating and a completely free-floating system. As it was designed, the managed floating system could not function in the face of a destabilizing speculative attack. The band was widened, as part of the IMF conditionality, but this did nothing to stem the tide of capital outflows and did not stop the depletion of reserves. Since then, the nominal exchange rate vis-à-vis the U.S. dollar has depreciated by more than 50 percent and its movements have been volatile, making the real exchange rate equally unstable. So far it appears that the depreciation and flexibility of the foreign exchange rate has done very little in the way of restoring foreign investors’ confidence. The difficult question is whether the foreign exchange rate should be allowed to depreciate continually until the markets’ sentiment turns around.

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The recent Korean experience is rather negative in this regard. As Eichengreen and Wyplosz suggest, emerging market economies like Korea with a large external sector are better advised to pursue a pragmatic policy that involves limited exchange rate management and the imposition of limited restrictions on capital movements.17 In the long run, they suggest that these countries should contemplate monetary unification with a larger neighbor. In the case of Korea, Japan is such a neighbor, but it accounts for less than 20 percent of Korea’s total trade, making it an impractical neighbor with which to unify. The process of worldwide financial integration will lead to creation of a single global market. To be tenable, such a market system must be supported by a global financial governance system that includes global rules and supervision of financial activities. In a domestic economy, the central bank stands ready to rescue a healthy bank suffering from a public panic by extending an unlimited amount of credit, if necessary. In an open economy, the central bank could not play a similar role as lender of last resort if a bank run ensues as a result of foreign investors’ panic. A free-floating system may not prevent a foreign exchange crisis caused by the financial crisis. As long as these institutional deficiencies of the international financial system remain, there may be a limit to which emerging market economies could deregulate capital-account transactions. Concluding Remarks: Reflections on the Crisis

The financial crisis in Korea has been much more severe than expected and has inflicted serious damage on the economy. Korea will not be able to completely recover from the economic dislocation brought on by the crisis for a number of years. The Korean experience naturally raises the questions of whether the crisis, in hindsight, could have been prevented in the first place and whether it could have been better managed once it broke out. What general lessons can we derive from the experience, and what are the implications of the crisis for the reform of the international financial system? There is no question that the Korean policymakers are largely responsible for the crisis. They have tinkered with much needed economic reforms for the real as well as financial sector of the economy for far too long, thereby deepening foreign investors’ distrust of the government. Furthermore, in 1997 the Korean policymakers did not pay enough attention to the sharp deterioration in various liquidity indicators and to complaints by foreign investors about either nontransparency in the management of corporations and financial institutions or the reliability of the published statistics on banking and foreign reserve holdings. Also the policymakers tried to defend the won for too long by maintaining a managed floating

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system, thereby causing the Bank of Korea to lose a substantial amount of reserves. At the same time, the deficiencies of the international financial markets have become more pronounced and have exacerbated the crisis, giving rise to far more extensive damage. The herd behavior and information problems on the part of investors were apparent during the Korean crisis. The herd behavior was compounded by moral hazard stemming from the implicit or expected loan guarantees by the Korean government and the recourse to IMF rescue financing. The East Asian crisis in general has shown that in an integrated financial world, financial crises can be contagious and pose systemic risk. To prevent financial crises in the future, what reforms or institutional changes should be contemplated? Creating a new lender of last resort or strengthening the role of the IMF as such a lender is controversial because few countries would be inclined to assume the cost of operating such an institution. Regulating and monitoring institutional investors in their source countries is claimed to be impractical and unnecessary. Regulation and monitoring of foreign lenders by borrowing countries would be regarded as capital control and completely against the spirit of liberalization. And even despite the fact that the IMF has acted as a de facto lender of last resort, many would object to the idea of giving that organization regulatory authority. In the meantime Korea has been under pressure, much more so after requesting IMF assistance, to completely open up its financial markets, thereby integrating its domestic market with the world financial system (which does not provide any public goods for global financial stability) while adopting a free-floating exchange rate system. This is an unsustainable situation, to say the least. When a domestic financial institution experiences a run on its deposits, the central bank stands ready to contain the bank run by making, if necessary, unlimited amounts of credit available. Withdrawals of funds from such an institution by foreign investors could lead to the insolvency of this bank, and if the run becomes contagious and affects other institutions, the central bank will have to lend from its holdings of foreign reserves. If the bank depletes its foreign reserve holdings, the country will then be forced to default on its debt repayments. Exchange rate depreciation and high interest rates could stop the run on the banking system, but the Korean experience demonstrates that they offer no guarantee. The ultimate outcome of the situation depends entirely on the markets’ perception. The system of floating exchange rates does not appear to be the most efficient arrangement for a small, open economy because it may cause large fluctuations in the real exchange rate. In a fully integrated financial world should the central bank in question be solely responsible for containment of the crisis? Other than the central bank of the country where the bank run is on, should there be a multilateral organization serving as lender of last resort?

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Most of the measures proposed so far for the prevention and better management of financial crises, such as creating an international lender of last resort, restructuring the IMF for regulating global institutional investors, and harmonizing rules and enforcement efforts at a regional or global level, are not likely to be instituted soon. Given this reality, and in view of the ongoing financial crisis in East Asia, the international financial community should have second thoughts about whether it would serve the interests of the advanced countries to demand a pell-mell opening of the financial markets of emerging market economies. Until the provision of public goods that will safeguard these countries from the recurrence of financial crises, the countries should be allowed to throw sand in the works of international finance, at least at the national level. Notes

Rudi Dornbusch and Jack Boorman of the IMF gave valuable comments on an earlier draft of this chapter. 1. During the 1995–1996 period, the short-term money market rates in Korea fluctuated between 13 and 14 percent, while the Libor on 90-day U.S. dollar deposits remained below 6 percent per annum. 2. During the 1986–1989 period, the capital and financial accounts generated a surplus on the order of $16 billion. 3. Since a large amount of private foreign debts will come due in the spring of 1998, it is feared that the inability of private firms to service their foreign debts could destabilize the financial markets once again. 4. Economic Review no. 29, Korea Institute of Economics and Technology (29 December 1997). 5. The share of short-term in total external liabilities at merchant banks is relatively lower, though the accuracy of their balance sheet figures have been questionable (see Table 6.6). 6. Barry Eichengreen and Charles Wyplosz, “What Do Currency Crises Tell Us About the Future of the International Monetary System?” in J. J. Teunissen, ed., Can Currency Crises Be Prevented or Better Managed? Lessons from Mexico. The Hague: FONDAD, 1996. 7. Securitized capital inflows in Table 6.5 include all long-term capital inflows plus foreigners’ portfolio investment and banks’ commercial paper financing. 8. To be fair, it is true that Korean officials alluded to the possibility of guaranteeing the repayment with interest of Korean banks’ foreign debts on several occasions even before the crisis broke out. 9. S. Griffith-Jones, “How Can Future Currency Crises Be Prevented or Better Managed?” in J. J. Teunissen, ed., Can Currency Crises Be Prevented or Better Managed?: Lessons form Mexico. The Hague: FONDAD, 1996. 10. Robert Z. Lawrence, Regionalism, Multilateralism, and Deeper Integration. Washington, D.C.: The Brookings Institution, 1996. 11. Griffith-Jones, “How Can Future Currency Crises Be Prevented or Better Managed?” 12. C. P. Kindleberger, Manias, Panics, and Crashes: A History of Financial Crises, 3rd ed. New York: John Wiley and Sons, 1996.

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13. Peter B. Kenen, “How Can Future Currency Crises à la Mexico Be Prevented?” in Can Currrency Crises Be Prevented or Better Managed: Lessons from Mexico. The Hague: FONDAD, 1996. 14. Griffith-Jones, “How Can Future Currency Crises Be Prevented or Better Managed?” 15. Kindleberger, Manias, Panics, and Crashes: A History of Financial Crises, 9–10. 16. Richard J. Herring and Robert E. Litan, Financial Regulation in the Global Economy. Washington, D.C.: The Brookings Institution, 1995. 17. Eichengreen and Wyplosz, “What Do Currency Crises Tell Us About the Future of the International Monetary System?”

Bibliography

Eichengreen, Barry, and Charles Wyplosz. “What Do Currency Crises Tell Us About the Future of the International Monetary System?” In Can Currency Crises Be Prevented or Better Managed?: Lessons from Mexico, edited by J. J. Teunissen. The Hague: FONDAD, 1996. ———. “Taxing International Financial Transactions to Enhance the Operation of the International Monetary System.” In The Tobin Tax, edited by Mahbub ul Haq, Inge Kaul, and Isabelle Grunberg. London: Oxford University Press, 1996. Griffith-Jones, S. “How Can Future Currency Crises Be Prevented or Better Managed?” In Can Currency Crises Be Prevented or Better Managed?: Lessons from Mexico, edited by J. J. Teunissen. The Hague: FONDAD, 1996. Herring, Richard J., and Robert E. Litan. Financial Regulation in the Global Economy. Washington, D.C.: The Brookings Institute, 1995. Kenen, Peter B. “How Can Future Currency Crises à la Mexico Be Prevented?” In Can Currency Crises Be Prevented or Better Managed? Lessons from Mexico, edited by J. J. Teunissen. The Hague: FONDAD, 1996. Kindleberger, C. P. Manias, Panics, and Crashes: A History of Financial Crises, 3d ed. New York: John Wiley and Sons, 1996. Lawrence, Robert Z. Regionalism, Multilateralism, and Deeper Integration. Washington, D.C.: The Brookings Institution, 1996. Park, Yung Chul. “The Republic of Korea’s Experience with Managing Foreign Capital Flows.” In The Tobin Tax, edited by Mahbub ul Haq, Inge Kaul, and Isabelle Grunberg. London: Oxford University Press, 1996. ———. “East Asian Liberalization, Bubbles, and the Challenge from China,” Brookings Paper on Economic Activity 2 (1996): 357–371. Park, Yung Chul, and C. Y. Song. 1997, “The Southeast Asian Currency Crisis and the Channels of Contagion,” paper presented at the conference at the Mitsui Life Financial Research Center, University of Michigan Business School, 6 November 1997, Ann Arbor, Michigan.

7 The Impact of the Asian Crisis on Latin America Latin American Economic System1

The full extent of the financial crisis that began in Thailand in July 1997 has yet to be measured vis-à-vis the global economy, as well as in regard to the countries of Latin America and the Caribbean. Although only the short-term repercussions have been gauged, a harder wave of medium- and long-term impacts will be felt in the macroeconomic framework of many countries and their external trade and finance relations. In recent months, global and regional economic forecasts have been reviewed to measure the costs spurred by this crisis, whose indirect and deferred effects, over a relatively longer term, will be at least as significant as the immediate costs recently detected. Based on forecasts of basic statistical indexes for international financing and trade flows and for capital market risk, this chapter illustrates elements that will determine the short- and long-term impact that the Asian crisis will have on a number of Latin American and Caribbean economies. All the information has been updated using data available as of January 1998; the evolution of the crisis has been followed until May 1998. Although the main Latin American stock markets suffered the effects of the financial storm that was unleashed by the devaluation of the Thai baht in July 1997, the Asian crisis did not noticeably affect the macroeconomic performance of Latin America in 1997. With a growth rate of approximately 5.5 percent, Latin America’s macroeconomic performance was in fact its best in the past 25 years. The effects of the lengthening and worsening of the Asian crisis would, however, be felt in 1998, and will affect Latin America in many different ways. The direct impact on trade as a result of declining Asian demand will be compounded by the indirect effects of the slowdown in world economic growth, which will be reflected, for example, in the fall of prices of commodities.2 As far as trade is concerned, there will also be a “competitiveness” effect as a result of the weakening of the currencies that were hardest hit by the crisis: Latin American products will have a hard 171

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time competing with Asian products in many markets. Furthermore, the persistent climate of mistrust regarding the “emerging markets” threatens to sustain or boost two aspects of the current situation that appeared last October: the “flight to quality” phenomenon and the rising price of external financing. This chapter will assess the impact of the Asian crisis on Latin America in 1998. The analysis concentrates on the most direct effects on trade and finance in seven of the region’s countries.3 The first section presents the relative position of these countries in financial risk rankings as they are usually perceived by international analysts. The next section highlights the extent of Latin America’s dependence on Asian markets as far as the former’s trade is concerned, as well as its vulnerability in the face of the drop in prices for raw materials. The third section examines the region’s external financing situation for 1998, and the last section presents conclusions. Risk Ratings: The Position of Latin American Countries

As mentioned above, the Asian crisis has generated an increasing lack of confidence in emerging economies. The prospects of emerging economies at the end of the 1990s will therefore be largely determined by the perceptions of international investors and analysts who evaluate them according to several criteria, including level of development, potential for growth, internal and external macroeconomic balances, political risk and the credibility of economic policy, and the situation of the banking system. In order to determine the risk ratings as they may be perceived at the moment, in other words, at the beginning of 1998, we have made an analysis of multiple correspondences on the basis of the variables generally used for quantifying the criteria mentioned above (see Appendix 7.1). The results obtained are presented in Figure 7.1. As expected, the resulting typology reveals the crisis afflicting Asian economies and its main consequences. This is presented through the configuration of the axes. The horizontal axis sums up the variables associated with internal macroeconomic performance (mainly growth in the period 1996–1997, inflation, and the status of public finances) to which the more qualitative variables that reflect the perception of political risk and the credibility of economic policy and the situation of the banking system are added. This axis separates the countries that enjoy a good reputation in international markets on the basis on the solidity of their “fundamentals” (group 1) from the rest. The vertical axis differentiates among the economies according to the recent evolution of their currencies (sharp devaluation in real terms or, on the contrary, relative stability of the exchange rate) and the extent of their

The Impact of the Asian Crisis on Latin America Figure 7.1

173

Emerging Economies: Financial Risk Ratings

Source: Authors, on the basis of the sources indicated in Appendix 7.1.

external financial vulnerability, which is expressed in terms of the relative importance of their current-account deficit and the solidity of their external position (ratio between international reserves and short-term foreign debt). Inasmuch as the turbulence sparked by the Asian crisis has still not died down, it seems logical to consider external financial credibility as an important determining factor. As we pointed out, group 1 consists of the countries least weakened by the crisis. Although it may seem logical to find Taiwan (as the least affected by its neighbors’ problems), Hong Kong (which successfully resisted a run against its currency at the end of October), and Chile (the only Latin American country in the group) in this group, it may seem surprising that Malaysia is also in this group. Its presence, however, reflects its financial credibility compared with the Asian countries most affected by the crisis; Malaysia’s status is consistent, as we shall see below, with the fact that the spreads of its Eurobonds have only increased slightly. Although it is very heterogeneous, group 2 consists of relatively solid economies that are, however, vulnerable because of the high levels of their external debts and the potential imbalances in their external trade, both of which are common to most of them. The Latin American countries that

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form part of this group are Argentina, Mexico, Uruguay (which is not analyzed in this study), and Venezuela. Group 3 is defined by the features of the countries that formed the epicenter of the crisis (Thailand, Indonesia, South Korea, and the Philippines): a sharp devaluation of the national currency and a level of external financial vulnerability that continues to be extremely high. Obviously, there is no Latin American country in this group. Finally, group 4 is characterized by diverse, macroeconomic imbalances, as well as a situation of potential financial volatility. Three Latin American countries fall into this group: Brazil, Colombia, and Peru. In any case, in a context of crisis and great volatility the resulting typology is not at all stable and cannot therefore provide a basis for predicting future developments. The “photograph” the typology produces does provide a fairly accurate picture of the current situation but it only partially reflects the recent course of events in the countries under study.4 This is fully verified when attention is focused on the crucial problem in a crisis of confidence: the situation of the banking systems. The relative improvement recorded by Latin American countries in this respect is not only the automatic result of the deterioration of the situation of the Asian financial establishments. The improvement also reflects the progress that has been made in the last 2 years. After the crisis of 1994–1995, the Latin American banking systems have been characterized by a vast restructuring process that has been accompanied by a gradual improvement in their performance indicators. A survey of 159 banks from Argentina (79), Brazil (66), and Mexico (14) on the basis of the information contained in the balances closed on 31 December 1994 and 31 December 1996 reveals that solvency ratios are improving considerably (as shown by the evolution of the disposable assets/total deposits indicator in Figure 7.2a). Liquidity indicators are also increasing significantly (see the disposable assets/total assets indicator in Figure 7.2b). Finally, there has been a relative decline in profit margins that reflects the costs of the adjustments and the clearing of doubtful loan portfolios (Figure 7.2c). A priori, this set of indicators reveals a cleaning-up process in the banking systems that is a positive factor as far as the region’s short-term prospects are concerned. However, it should be pointed out that the growth forecasts for 1998 are not significantly associated with either of the axes. This can be attributed to the fact that current predictions are still far from appreciating the magnitude of the changes wrought by the crisis of confidence that is affecting most emerging economies. The forecasts also fail to fully consider the macroeconomic effects of the adjustment plans that have been implemented in recent months. Table 7.1 shows the forecasts that have been made for the countries of Latin America and Asia. The 1998 forecasts made prior to the crisis of July

The Impact of the Asian Crisis on Latin America Figure 7.2

Argentina, Brazil, and Mexico: Recent Evolution of the Banking System

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Table 7.1 Growth Forecasts for Latin America and Asia in 1998 (Annual variation as a percentage) Latin America

Argentina Brazil Chile Colombia Mexico Peru Venezuela Average

Korea Indonesia Malaysia Thailand Philippines China Hong Kong Singapore Taiwan Average

Growth Precrisis Differences: 1998 forecast observed forecast macroeconomic made in in 1997 for 1998 adjustments January 1998 (1) (2) (3) = (2)–(1) (4) 7.70 3.70 6.30 3.00 7.10 7.10 5.00 5.70

5.70 3.70 6.80 4.60 5.30 4.30 5.60 5.14

–2.00 0.00 0.50 1.60 –1.80 –2.80 0.60 –0.56

Asia

4.30 0.00 4.50 3.50 5.00 4.00 3.50 3.54

Growth Precrisis Differences: 1998 forecast observed forecast macroeconomic made in in 1997 for 1998 adjustments January 1998 (1) (2) (3) = (2)–(1) (4) 5.60 4.50 6.80 0.00 4.50 9.00 4.80 7.20 6.30 5.41

6.10 7.60 8.00 5.30 6.10 10.40 5.50 7.20 6.40 6.96

0.50 3.10 1.20 5.30 1.60 1.40 0.70 0.00 0.10 1.54

Sources: Consensus forecast and authors’ predictions.

–0.10 –0.60 2.60 –2.00 3.00 8.50 3.10 4.60 6.10 2.80

Differences: Total Impact of the differences Asian crisis (5) = (4)–(2) (6) = (3)+(5) –1.40 –3.70 –2.30 –1.10 –0.30 –0.30 –2.10 –1.60

–3.40 –3.70 –1.80 0.50 –2.10 –3.10 –1.50 –2.16

Differences: Total Impact of the differences Asian crisis (5) = (4)–(2) (6) = (3)+(5) –6.20 –8.20 –5.40 –7.30 –3.10 –1.90 –2.40 –2.60 –0.30 –4.16

–5.70 –5.10 –4.20 –2.00 –1.50 –0.50 –1.70 –2.60 –0.20 –2.61

1997 estimated an average growth of 5 percent for the seven Latin American countries under consideration. This rate reflected a fall of less than 1 percentage point (compared with the growth rate for 1997) mainly due to internal macroeconomic adjustments aimed at preventing an increase in external imbalances: a fall in the growth rate of Argentina (of 2 points), of Mexico (of 1.8 points also due to the United States’ entry into the slowdown stage of its growth cycle), and of Peru (of 2.8 points). The growth rates of these three countries were over 7 percent in 1997. The forecasts made in January 1998 reflect a further fall in the region’s growth rate to around 3.7 percent, which could imply that the Asian crisis has cost the region 1.5 growth points. This figure of 3.7 percent is obtained by taking the following into account: a situation of 0 percent growth in Brazil, the 1.4-point fall in Argentina’s growth (related to the

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performance of its main client, Brazil, and the internal adjustments that were needed to reduce external financial imbalances), the 2.3-point drop in Chile’s growth (mainly due to the fall in the value—volume and prices— of its exports to Southeast Asia), and the 2.1-point decline in Venezuela’s economic growth (due to the sharp drop in oil income). As far as the Asian countries are concerned, forecasts predicted a drop of over 4 points compared with the growth estimates made prior to the crisis to almost 3 percent GDP growth for 1998. As mentioned above, however, these figures may be revised downward yet again (mainly in the cases of Korea and Indonesia). A downward trend of this kind cannot fail to affect the growth prospects of Latin America, especially in the case of the countries that have established considerable trade ties with Asia. Foreign Trade: Poor Prospects

Although Latin America’s overall trade relations with Asian countries are relatively limited (Asia represents around 10 percent of the region’s total exports), some Latin American countries do carry out a significant level of trade with Asia (see Table 7.2). A significant percentage of Chile’s and Peru’s total export and to a lesser extent of Brazil’s and Argentina’s go to Asian countries. All of these countries will be affected by the sharp drop in Asian economic growth, and in the case of Peru and especially Chile, they will feel most the impact of the Asian crisis in trade. It is interesting to note that Latin American exports to Asia grew rapidly during the first 8 months of 1997 (Figure 7.3). This probably reflects the Table 7.2 Percentage of Latin American Exports Purchased by Asiaa Argentina Brazil Chile Colombia Mexico Peru Venezuela

1990 10.20 1991 10.97 1992 9.33 1993 9.50 1994 11.11 1995 12.22 1996 12.12 1996 (9 months) 11.71 1997 (9 months) 14.99

16.78 17.98 15.05 15.90 16.26 17.49 16.24

24.55 29.60 30.80 30.67 32.49 33.86 33.29

16.98 33.50

15.28 38.12

4.53 4.11 3.62 4.53 5.50 5.96 4.30

4.43

3.86

6.70 3.73 2.43 2.19 4.25 2.53 3.27

3.54

3.33

Source: IMF DOTS. Notes: a. Asia includes Japan; b. millions of dollars.

20.93 22.13 24.94 24.07 27.03 26.03 23.83

23.82

25.33

3.96 3.56 3.23 2.85 2.19 2.70 1.87

1.84

1.90

Latin America Valueb %

12,408.10 12,886.70 12,533.20 13,068.30 17,481.30 20,807.30 21,226.00

16,309.70

11.26 10.54 9.63 9.41 10.62 10.51 9.50 9.90

17,861.40 10.27

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fact that Asian importers increased their foreign purchases in the anticipation of the devaluation of their own currencies. This phenomenon is patently clear in the case of Chile: in August 1997, over 40 percent of its exports went to the Asian market (Figure 7.4). This advance purchasing by Asian importers explains why the subsequent plunge in these imports was greater than the drop that would be expected as a result of the slowdown in Asian economic growth. At the same time, the prices for raw materials, which still constitute a significant export item in Latin America, also fell. Figure 7.5 shows that after tending to rise over a period of 4 years, the prices of basic products began to fall in July 1996. This downward trend was worsened by the Asian crisis. Table 7.3 shows that the accumulated drop in the general index of commodity prices was 6 percent between January 1997 and January 1998, while the drop between July 1997 and January 1998 was 7 percent. This downward trend varies according to the commodities in question. The fall in cereal prices has been of little significance, and the sharp drop in coffee prices during the second half of 1997 does not outweigh the boom recorded during the first half of that year (Table 7.3 and Figure 7.6). The two most affected products are in fact copper and oil. In the case of the latter, the decline in prices that started at the beginning of 1997 and became steeper at the end of the same year (Table 7.3 and Figure 7.6) was brought about by, among other things, excessive supply and a high level of stocks in the United States, the OPEC’s decision in November 1997 to raise production by 10 percent in January 1998, and the possibility of the United Nations’ authorizing the increase of Iraq’s exports. The uncertainty surrounding the repercussions of the Asian crisis in the world economy is depressing the oil market further, and its weakening will obviously affect the region’s main exporters (Venezuela, Mexico, Ecuador, Colombia, and Argentina). The drop in copper prices, however, seems to be much more closely linked to the Asian crisis. The decline in fact began in July 1997 and has reached 40 percent in accumulative terms between then and January 1998 (Table 7.3 and Figure 7.6). This particularly affects Chile: the Asian market absorbed around 53 percent of its total copper exports in 1997. Questions About External Financing

In addition to the poor prospects on the trade front, a certain amount of uncertainty now surrounds Latin America’s external financing in 1998. The region has significantly reduced its dependence on the more volatile sorts of financial flows. Net direct foreign investment represented $44 billion of slightly over $73 billion of net capital entries in 1997. In

The Impact of the Asian Crisis on Latin America Figure 7.3 Monthly Evolution of Latin American Exports to Asia (millions of current dollars)

Figure 7.4 Chile: Evolution of Asia’s Participation in Total Exports

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Figure 7.5 Evolution of the General Price Index for Commodities

Sources: Datastream, CRB. Table 7.3 Prices of Commodities (Variations expressed as percentages)

June 1997 July 1997 August 1997 September 1997 October 1997 November 1997 December 1997 January 1998 June 1997/January 1998 June 1997 July 1997 August 1997 September 1997 October 1997 November 1997 December 1997 January 1998

Index –2.7 –3.1 2.0 0.5 0.6 –1.6 –2.4 –3.1 –7.1

–2.4 –4.0 –3.0 –1.7 –0.4 –0.9 –3.5 –6.2

Sources: Datastream, CBR.

Copper

General Prices Oil

Coffee

Monthly variations since June 1997 3.1 –7.8 –13.4 –8.0 4.1 –19.4 –4.3 1.4 2.3 –3.1 –1.3 0.0 –2.1 8.0 –24.4 –10.2 –4.2 –4.7 –9.1 –10.3 9.5 –6.3 –11.7 –3.7 –43.2 –13.9 –40.3 Annual variations since 1997 6.4 –4.3 60.0 15.1 –6.1 44.6 9.1 –9.1 41.2 4.6 –21.7 50.6 3.4 –18.7 32.4 –7.4 –17.9 22.6 –20.6 –32.2 30.1 –28.8 –42.1 15.7

Cereals –6.6 –4.9 3.6 2.2 3.5 0.5 –3.2 2.8 –1.2

–27.0 –31.1 –21.5 –15.7 –3.5 3.0 1.9 –1.5

Sources: Datastream, CRB.

Figure 7.6 Average Monthly Evolution of Commodity Prices (Selected products)

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contrast to the situation during the period 1991–1994, in 1997, short-term capital only represented a small fraction of the net financial flows received by the region.5 Nevertheless, if the portfolio investments in emerging countries continue the downward trend that began in the last months of 1997 (one of the manifestations of the “flight to quality” mentioned above), the foreign financing available to Latin America will decrease. This may coincide with a slight fall in direct investment if it is confirmed that certain Japanese and Korean groups have decided to postpone the investments planned for 1998. The problem of gaining access to the international Eurobond market is more significant, however. In 1997, Latin American countries’ gross issues in this market reached $53 billion.6 The Asian crisis has resulted in the delay of various issues planned by Latin American countries at the end of 1997 and has, more importantly, increased the spreads. Figure 7.7 presents the risk premiums of the sovereign issues of a number of emerging countries that have 3-to-6-year maturities and shows that the Asian crisis has produced an average increase of 165 base points above the U.S. Treasury bond rate (which is zero risk). As expected, the most spectacular increases were recorded by Thailand’s, South Korea’s, and, above all, Indonesia’s securities. Indonesia’s precrisis spread level was extremely low, but the increase in the next few months showed that the markets considered its securities a default risk. The spreads of Latin American countries have also suffered increases that range from 105 to 204 base points.7 The countries most affected were Figure 7.7 Average Increase of Eurobond Spreads Between June 1997 and January 1998 (Percentage points above U.S. T-Bill yield rate)

Sources: Datastream.

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Mexico (whose increase was only slightly less than the general average) and, above all, Argentina and Peru. These latter two countries have had to deal with significant external debt amortizations in 1998, and the reopening of the Eurobond market is therefore essential if they are to avoid a liquidity crisis. The return to a more normal situation in terms of issue volumes will enable the impact of the Asian crisis in terms of refinancing costs to be determined. Obviously, if the conditions regarding liquidity and international interest rates remain favorable, the reopening of the Eurobond market may be accompanied by a gradual decrease in the spreads. This, however, depends on the main sources of instability in Asia disappearing and no new crises arising. The Financial Crisis in Asia: Different Perceptions

The debate over the causes of the Asian crisis is complex. It assigns the blame and responsibilities to one or the other actor, depending on the economic and political leaning of the analyst, and probably will last for some time. Furthermore, given the short time that has elapsed at the time of this writing, all attempts at analysis presuppose a high degree of speculation. This chapter does not purport to explain the crisis. However, to deal with a topic that is of great interest to Latin America and the Caribbean, it is necessary to indicate what are the principal elements, of a temporary and structural nature, that underlie the debate. Structural and Temporary Factors of the Crisis

A slowdown in growth took place in Eastern Asia in 1996, with the average growth rate decreasing from 9 percent in 1994 and 1995 to 7 percent in 1996. In part, this decrease was the result of restrictive government policies to prevent an overheating of the economies with a very high growth rate (e.g., Indonesia, Malaysia). Nonetheless, an important decrease in the rhythm of expansion in exports had already taken place, in view of the government policies to contract global demand, a decrease in international consumption of electronic products,8 and a significant loss of competitiveness by those countries in comparison with China, which had undergone its own devaluation in 1994 with a 50 percent reduction in the value of the renminbi against the dollar. The same situation was present in regard to other countries, in view of a 40 percent increase in the value of the U.S. dollar between 1995 and 1996, to which the currencies of the “Asian tigers” were closely tied. In addition, the 1996 depreciation of the yen made access difficult for the products of the “tigers” and “dragons” to the Japanese market, while making it more expensive to import Japanese equipment.

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Structural weaknesses came to light along with the interim elements. Among these we can cite the following (although the importance of the factors and the situations vary in each country):

• Slowdowns of industrial productivity growth and salary increases • Difficulties in the transition from labor-intensive industries to those intensive in know-how (indicating inadequately trained human resources) • Specialization excessively concentrated in only a few sectors • Fragility in and failure to adapt the banking sector • Distortions in the operations of institutions to the benefit of specific economic groups in some countries • High-risk speculative investments (i.e., real estate) • Overinvestment in industrial plants and other projects because of abundant financial resources • High, very short-term internal debts and, in certain cases, external debts (e.g., Indonesia)

These processes have generally appeared in political and social contexts that have reached a tense and turbulent phase, such as in South Korea, Thailand, and Indonesia. A Clash of Views

The different combination of and emphasis given to these factors by analysts and other interested parties contributed to the generation of varied interpretations of the process among specialists.9 In the Western economic press, particularly in the United States, the writers and multilateral financial institutions tended to assign a major portion of the responsibility to the governments of the Asian countries. The application of sociopolitical concepts, principles, and regimes of different cultural roots (the “Asian values”) and the adoption of policies based on views different from the interests and actions required to achieve growth, particularly the close links in the government-businessfinancial sector, were seen as playing a central role in this crisis. However, in the Asia-Pacific region, there is the perception that the behavior of the financial actors, the diagnosis made by the IMF and the World Bank, and the measures the latter require the countries to adopt to overcome the crisis and be eligible for financial aid form a part of a double strategy. That is, the financial operators geared to making unprecedented profits in the short term and depreciating the value of Asian companies will make the companies’ subsequent acquisition by U.S. and European companies and banks easier, and that of the multilateral financial institutions, particularly the IMF, which will force the opening up and liberalization of Asian markets and introduce profound reforms in the political, economic, labor, and real estate systems.

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Any espousal of conspiracy theories is obviated here because a substantial portion of the short-term capital used for speculation was provided by Japanese and Asian banks and operators, not just by those in the West. However, the IMF’s terms could be questioned for both the strategy adopted to overcome the crisis and for including requirements to open up and restructure the Asian economies, in keeping with the dominant economic approach and interests of certain Western business groups and countries.

Appropriate Political Proposals and Solutions?

What the appropriate treatment should be for resolving the Asian crisis is a complex topic that has sparked an important debate about the potential positive or negative effects of a set of common policies applied to the affected countries. The policies would include stringent fiscal austerity measures and a profound monetary adjustment, which could generate a significant recession. It is necessary to adopt measures to reestablish confidence in overly sensitive Asian markets, but care must be taken not to lose the positive effect of modifying exchange rates, because of the unfavorable impact of high bank interest rates (which substantially restrict access to credit) on the capabilities of companies to honor their financial obligations and recover the rhythm of exports. The formula used by the IMF in handling the crisis is considered to be inadequate by Joseph Stiglitz, a World Bank economist, as well as by Jeffrey Sachs and other reputable economists. The formula basically repeats the structural adjustment programs used in Latin America and in other countries in the 1980s. It emphasizes government cost reduction and budget cuts, full restructuring of national financial systems,10 and deregulation, privatization, and overall liberalization of the economies. In fact, it might be more advisable to allow the countries to service their debts by using the profits from future exports. To do so current loans would have to be extended (instead of making new loans at very high interest rates) and fresh funds, at accessible rates, would have to be made available to restructure the financial system. At the beginning of the 1980s, the IMF introduced its first structural adjustment project in Latin America and East Asia to stabilize foreign accounts and begin to open up the economies. The signing of the “Plaza Hotel Accords” in 1985, which sharply increased the value of the yen against the dollar to lessen the effects on the United States of its trade deficit with Japan, led to a massive exodus of transnational companies and Japanese capital, which were relocated to the Asia-Pacific region, thus substantially contributing to generating the regional growth process known as the “flight of the geese.” With support from this process, the countries of the Asia-Pacific region were able to apply, among other things, their “managed capitalism” and keep control of the degree to which their trade and financial systems

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opened up. This allowed them to significantly contain the pressures exerted by the bilateral trade policies that the United States had adopted during the Reagan administration to ensure the opening up of the markets in developing countries. Over time, this design of U.S. trade policy incorporated the use of new and more sophisticated mechanisms that added the transregional (Asia-Pacific Economic Cooperation Group, or APEC) and the multilateral (WTO) dimensions. In this context, the financial crisis of July 1997 obliged the IMF to negotiate with governments the opening of their economies and the implementation of aid programs in Thailand, South Korea, and Indonesia—although at the time of this writing there were still difficulties in the latter country.11 These programs include such measures as removing the restrictions on owning national financial firms by foreign companies (Thailand and South Korea), more liberal legislation for foreign investments (Thailand), and actions to make implementation of a “national automobile” project more difficult by imposing restrictions on the development of a national aeronautical industry in Indonesia. Elements for Evaluating the Crisis

Including Japan, Asian countries’ participation in the world economy now represents one-fifth of the world economic ouput, three times the 1970 share.12 And the increase in the degree of financial globalization has contributed to the fact that the area’s financial crisis has had a greater impact than ever before, affecting the European Union, Japan, and the United States.13 Furthermore—and unlike prior crises—this time the epicenter was in the private and not the government sector. This factor gave a warning about the limitations of the market in efficiently allotting resources.14 A very permissive lending policy was apparent, and few precautions were used by international financial entities, in search of huge profits and speculative investments, against excessive indebtedness in the private sector. This has not been generally acknowledged by the affected governments. Thus, as the director of the U.S. Federal Reserve pointed out, there was an injection of investments into those economies that was higher than could appropriately be used with a moderate risk. The net inflow of private capital to Indonesia, Malaysia, South Korea, Thailand, and the Philippines jumped from $41 billion in 1994 to $95 billion in 1996, represented for the most part by short-term loans. The concerned governments could be criticized for failing to implement either supervisory methods on a timely basis or appropriate regulations for their banking systems. However, it is not easy to prevent an overexpansion of internal credit when there is a rapid inflow of large quantities of external resources, and even with appropriate bank supervision it is difficult to control private-sector indebtedness abroad.15 Private investments abroad, not by banks but by the transnational corporations, amounted to

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one-third of the loans in South Korea and approximately 60 percent of those in Malaysia, Thailand, and Indonesia. Possible Consequences on the Trade Level

Although this is not the place to precisely determine the future evolution of the economies of South Korea, Thailand, Malaysia, Indonesia, and the Philippines, nor the effect of financial crises on trade flows, the following comments can be made:16 • The above five countries, despite their dynamism, do not as yet account for a substantial portion of the world economy (i.e., they account for 3.6 percent of the world GNP and absorb 6.0 percent of FDI). Thus, if the impact of the crisis is confined to those countries, global repercussions will be modest. • The impact on the regional level will be felt with greater force, however, given the decrease in the demand for imports from the region. This group of countries accounts for 7 percent of world trade, and in the Asia-Pacific region intraregional trade is quite important: from 40 to 60 percent of exports are within the region itself. The decrease in the value of the U.S. dollar due to devaluation has led to a reduction in imports.17 • In early March 1998 there were no signs that the expected and important increase in exports from the Asia-Pacific region to the rest of the world would occur. Rather, the growth in exports has been moderate and in some cases has fallen. In part, the serious difficulties faced by the supply and credit circuits, added to the previously mentioned fall in regional demand, have affected production.18 • As Asian economies recover, an increase in exports should be expected; however, although the United States imported 8.6 percent of the total products from those countries, the Asia-Pacific region represented only 2.5 percent of total imports in Western Europe. Japan alone accounted for 16.5 percent of the imports from the five Asian countries.19 In the case of Latin America, the average trade with the Asia-Pacific region represents approximately 10.0 percent of total imports and exports of the region. In this context, even an important rise in exports from the Asian countries most affected by the crisis should not, in principle, create significant problems for the world economy.

Importance of the Congressional Debate on U.S. Foreign Policy

The impact of the Asian crisis on the orientation of important foreign policy making in such industrialized countries as the United States exceeds the quantitative dimension of the crisis. In the United States, the Asian financial crisis has increased the unease that already existed there about the

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undesirable effects of economic globalization. Both legislators and their constituents show growing concern over and resistance to adopting commitments and measures that, in their opinion, represent higher costs and increase the vulnerability of the U.S. economy or restrict its freedom of action in the international economic system. The drop in the price of shares on Wall Street that lasted some time, the threat of a wave of Asian exports under very competitive conditions, a fall in U.S. imports into the Asia-Pacific region as a result of contraction in demand in that area, and the request for new funds ($18 billion) so that the IMF could aid the affected economies were factors that negatively affected different issues discussed by the U.S. Congress in 1998 (an election year).20 These issues covered the role of the IMF in a new “architecture” of the global economic system, the objectives that the aforementioned financing should have in the Asia-Pacific region, and, indirectly, the negative effects on the Clinton administration’s efforts to obtain approval of “fast track” negotiations over a “Free Trade Area of the Americas” (FTAA). With respect to the role of the IMF and the replacement of its funds, members of the most conservative wing of the Republican Party in the United States see the IMF as a threat to U.S. sovereignty and, along with other legislators, wish to introduce reforms in IMF procedures. Liberal Democrats, on the other hand, maintain that any financing for the AsiaPacific region must be contingent upon improving labor rights in the area. Other Democratic congressmen see the crisis as an excellent opportunity to introduce significant reforms in Asian economies, including reductions in trade barriers and support from those governments to their industries.21 Conclusion

The simultaneous consideration of the sources of internal vulnerability and the direct international ways in which the Asian crisis has affected that region that have been studied in this chapter enable a more precise assessment of the impact of the current situation on each Latin American country. The summary in Table 7.4 suggests that despite the diversity of their national situations, as far as this study is concerned, the countries fall into two groups. On the one hand are Argentina, Brazil, and Peru, which are potentially the most affected by the Asian crisis. Argentina and Brazil have been placed in a weaker position due to their (re)financing needs, while Peru is most affected because of its foreign trade possibilities. Colombia, Chile, Mexico, and Venezuela, on the other hand, at first seem to be in a less vulnerable position with respect to the Asian crisis. Colombia, Chile, and Venezuela are mainly affected by the drop in prices for commodities, although Mexico’s vulnerability is not excessively concentrated in one factor. Chile’s position is affected by its trade relations with Asia. Its vulnerability on the trade front is partially compensated,

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Table 7.4 The Impact of the Asian Crisis on Latin America: A Summary Presentation

Argentina Brazil Peru Colombia Chile Mexico Venezuela

Global Financial Situation – — – – + – –

Trade

Relations with Asia

Legend: — (highly negative impact) + (positive impact) – (negative impact) 0 (neutral impact)

– – — 0 — – 0

Direct impact Price of commodities – 0 — — — – —

Finance

External financing: Access and cost — — 0 0 0 – 0

however, by the solidity of its overall financial situation and the high credibility its handling of economic policy inspires. Finally, two particularly important observations should be made. First, as has already been pointed out, a certain number of indirect effects that are difficult to measure have not been taken into account even though they could have a decisive influence in the crisis discussed here. In addition to the “competitiveness effect” in a globalized economy the existence of systemic financial risk in the developed countries (considering the possible domino effect provoked by the weaknesses of the most exposed institutions in Asia) could generate a worldwide illiquidity process. A more pronounced slowdown in the economic growth of the OECD countries than the one expected would, among other things, lead to less demand for raw materials (and a consequent downward trend in prices). Also this chapter has not systematically taken the “multiplying effects” into account. These effects are the supplementary weaknesses derived from the difficulties encountered by the countries’ trading partners (e.g., Argentina and Chile with respect to Brazil). Second, this analysis of the most direct effects of the Asian crisis does not take into account the response capacity of the Latin American countries considered. The effects analyzed here should not be taken as unavoidable facts. Their repercussion on the workings of the region’s economies largely depends on the economic policies adopted. Government authorities have in fact reacted, and in most cases reacted quickly, by modifying aspects of their monetary, fiscal, and trade policies. On the financial front, and bearing in mind the comments made in other parts of this chapter, the economies most affected by the Asian crisis in our region—Brazil and Argentina—show significant signs of recovery. Brazil, for example, showed at the time of this writing promising signs

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of growth for the next few years according to evaluations by different organizations, banks, and international consultants. Five months after the crisis of November 1997, the Brazilian government returned to the international market by successfully issuing new notes in New York for $500 million for 30 years with Godman and Morgan.22 In the second half of 1998 there will be a new issue in German marks for $411 million. Both issues are a test of the international market for Brazilian companies that need to refinance their foreign debts, and to date have had favorable results.23 To this we can add the drop in interest rates and an estimate that the growth in GNP will be from 0 to 1 percent in the second half of the year. It is still premature, however, to make predictions about trade. In the case of Mexico, for example, there is the possibility of a reduction in exports in the textile sector in 1998 because of competition from cheaper products from the Asia-Pacific region.24 We have examined the main issues connected with the Asian financial crisis and how they might affect Latin America and trade relations between these two regions. However, we bear in mind the two components of the Chinese ideogram for “crisis” wherein what is perceived to be a “problem” is also an “opportunity.” In this context, the problems being confronted can also provide a space for beneficial cooperation between the AsiaPacific region and Latin America and the Caribbean. Appendix 7.1

The factorial analysis of multiple correspondences (AMC) is an instrument used to analyze the underlying structure of a large number of variables. This kind of analysis enables a large number of (quantitative and/or qualitative) variables to be transformed into a small number of independent variables. The latter, which arise from the combination of the basic variables according to their degree of association, constitute the orthogonal factorial axes. These axes define the spaces in which the countries of the sample are then situated. The typology that arises from the AMC enables the individuals or observations (in this case countries) that are closest in kind, in relation to a determined set of variables, to be grouped together and the most differentiated groups possible to be formed. Rather than reasoning on the basis of an average individual (or average observation), this typology enables individuals (or observations) to be placed in groups that each have their own logic. The intragroup variation must be as small as possible, and the intergroup variation must be as large as possible. The groups dissociate themselves in the cloud of observations. The 31 emerging countries subjected to the AMC are grouped according to a combination of six large criteria based on quantitative and qualitative variables:

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• Apparent level of development: per capita GDP in purchasing power parity dollars (of 1996) • Growth: GDP variation between 1996 and 1997; average investment/GDP 1993–1997; variation in exports in 1997; GDP growth predicted for 1998 • Macroeconomic balance: inflation (variation of consumer prices) in 1997; budget balance/GDP in 1997; credibility in economic policy (fourth quarter of 1997) • External accounts: external debt servicing/exports in 1997; currentaccount balance/GDP in 1997; trade balance variation in 1997; international reserves less short-term external debt/GDP in 1997; variation in real exchange rate in the period 1996–1997 • Situation of the banking system: the system’s solvency indicator (fourth quarter of 1997) • Political risk: indicator of apparent political stability (fourth quarter of 1997)

The sources of the quantitative variables are Datastream, World Bank, and national sources. The qualitative variables (credibility of economic policy, indicator of banking system solvency, and indicator of apparent political stability) are measured on a scale of 0 (high credibility and stability and minimum risk) to 100 (zero credibility and stability and maximum risk). This scale has been taken from that used by the international rating agency DRI–Standard & Poor’s (Global Risk Service). Notes

1. The Permanent Secretariat of the Latin American Economic System (SELA) thanks Egidio Luis Miotti and Carlos Quenan, professors at the University of Paris 13, for preparing this chapter together with Carlos J. Moneta. 2. The IMF revised its forecasts for world growth in 1998 from 4.5 percent prior to the Asian crisis to 3.5 percent at the end of 1997. 3. These are Argentina, Brazil, Colombia, Chile, Mexico, Peru, and Venezuela. 4. The quality of the factorial analysis (which as mentioned considers the basic criteria used by international financial analysts) can be measured by correlating the relative positions of the countries with the risk premiums of the sovereign Eurobonds market. The result is that over 70 percent of the premium levels are explained by the factorial coordinates. 5. CEPAL (UN Economic Commission for Latin America), Balance preliminar de la economía de América Latina y el Caribe 1997 (Santiago de Chile: United Nations, December 1997). 6. Ibid. 7. Figure 7.7 includes all the Eurobond issues of all the emerging economies. Chile and Peru are not present because they do not issue sovereign securities in international markets.

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8. Institute Français de Relations Internationales (IFRI), “L’acutalité économique internationale,” RAMSES 98 (Paris: Dunod, 1998), 152–153. 9. See, for example, L. Lim, “Crisis and Conspiracy,” Far Eastern Economic Review (18 March 1998): 31 and the comments of Prime Minister Mahathir of Malaysia regarding stockbrokers. See, among others, P. Krugman, “The Myth of Asia’s Miracle,” Foreign Affairs, 73 (March, December 1994); Young, “The Tyranny of Numbers—Confronting the Statistical Realities of the East Asian Growth Experience,” NBER Working Paper, 1994; Jong-Il Kim and L. Lau, “The Sources of Economic Growth of the East Asia Newly Industrialized Countries,” Journal of Japanese and International Economies, 8 (1994). In Latin America, among others, M. Gavin and R. Hausmann, “What We Have Learned from the Asia Crisis,” Latinfinance, 94 (1998): 111–112. 10. UNCTAD, La crísis financiera en Asia Oriental, Information Note, Geneva (30 January 1998), 2–3. 11. In January 1998, the government of Indonesia and the IMF signed an agreement for financial assistance to the latter country for $33 billion in exchange for the implementation of a far-reaching package of reforms. Nonetheless, President Suharto, elected for a new period last March, declared these policies to be contrary to the constitution of the country and postponed the implementation of the agreement. 12. J. A. Berkinschtein, “Asia en Crisis: Via Asiática o Paz Americana?” Working paper, Buenos Aires (February 1998), 3. 13. According to IMF estimates, at the end of 1996 European banks had lent the region $318 billion, the U.S. banks $46 billion, and the Japanese banks $260 billion. Far Eastern Economic Review (12 February 1998): 47. 14. UNCTAD, La crísis financiera, 2. 15. In the case of Indonesia, the government did not have reliable data about the indebtedness of the private sector abroad because such information was not declared by the companies. As a result of the crisis it was confirmed that the amount was substantially higher than estimated by finance authorities. See Ambassador Amin Rianom, “Los países de ASEAN y la crísis asiática. Perspectiva de Indonesia.” Conference, Instituto de Altos Estudios de America Latina, Universidad Simón Bolívar, 24 March 1998. 16. Although it does not fully coincide with the evaluations made therein, this section is based on the document “The Growth of World Trade Accelerated in 1997, Despite Agitation in Certain Asian Financial Markets,” WTO (Geneva, 19 March 1998), 11. 17. These reductions are about 14 percent in Japan, 17 percent in Indonesia, and 40 percent in South Korea in the first 6-month period of 1998. In this regard, refer to the Ministry of the Economy, Coyuntura en Asia. La Economía del Este de Asia en marzo de 1998, Assistant Secretary of Foreign Trade, working paper 14 (Buenos Aires), 3. 18. Ibid. 19. WTO, “The Growth in World Trade,” 11. 20. Regarding these issues, see SELA Antenna in the United States 42, Permanent Secretariat of SELA (January 1998). 21. Ibid. 22. “Governo volta a lançar títulos de 30 anos no exterior,” O Globo, Brazil, 21 March 1998, 27. 23. The cost of those securities before the Asian crisis was 3.5 points higher than U.S. Treasury bonds. In November 1997 the cost was approximately 7 points higher than U.S. Treasury notes. The securities launched in March 1997 were placed at a cost of 4.4 percent higher than U.S. Treasury bonds. 24. El Economista, Mexico, 25 February 1998, 35.

PART 3 Present and Future Challenges

8 The Process of Globalization Luis Enrique Berrizbeitia

Globalization is a complex and multifaceted phenomenon that requires some preliminary considerations before discussing it from a G-24 perspective. It involves, among others, a large and increasing variety of human activities that cut across technological innovation; global communications; the internationalization of commercial, financial, and economic activities across countries and continents; and political and cultural dimensions. It is therefore not exclusively a technological and economic phenomenon, as it is often perceived, but a complex and dynamic process involving multiple activities, variables, and forces interacting simultaneously. It is perfectly valid to compare the current process of globalization with that of before World War I, as is frequently done, at least in terms of their relative financial and commercial impacts. It seems, however, that such a comparison understates certain characteristics of the current globalizing process, which make it qualitatively different from the earlier one. In particular, the current process has a worldwide reach; its breadth, speed, and intensity seem to be substantially larger than they were in the past, and the corresponding impacts on societies and individuals may be correspondingly more intense as well. Comparatively speaking, globalization is evolving parallel to the evolution of computer technology since the 1970s; but individuals have not necessarily evolved mentally, intellectually, or emotionally to adapt indefinitely to the rates of change imposed by the evolution of technology. (Whether such asymmetry will eventually lead to a slowdown, halt, or reversal of the globalizing process is an open question that I will not attempt to address in this chapter.) Another issue we can dispense with early on is whether it is feasible for an individual, society, or nation to avoid or withdraw from globalization, for this chapter’s observations are not aimed at convincing anyone that globalization and the continuous process of change it entails are inescapable facts of current reality. Indeed, if it were possible to withdraw indefinitely from the process of globalization, it would be difficult to 195

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explain why the former Soviet Union broke up. Such was the strength of the many-faceted forces of globalization—economic, political, cultural, informational, and, of course, military—that even an extremely powerful Soviet Union was not able to withstand the effects of its cumulative pressures. It is also unlikely that the remaining holdouts, such as Cuba and North Korea, will be able to withstand such forces much longer. Furthermore, the inevitability of globalization applies as much to individuals and societies as it does to nations and countries, and has important implications for education and the role of governments in education, as we will explore later on. Having made these preliminary comments, because the G-24 is dedicated fundamentally to financial and economic issues on an international scale, the major proportion of this chapter will concentrate on these particular facets of the globalizing process. In particular, it will first attempt to provide a brief description of the principal elements of economic globalization, followed by a discussion of the basic policies required for countries to benefit from and mitigate the risks of globalization. The issue of the role of the state in the context of globalization will also be addressed, and the chapter will conclude with some thoughts on issues and implications for the G-24 derived from globalization. Elements of Globalization

The mechanics of economic globalization encompass trade liberalization (including that through the establishment of regional economic groups), sharply increased capital mobility, and the information revolution that has sharply reduced the cost of information while multiplying its availability a thousandfold through technological innovation and the resulting global reach of information transmission. These mechanisms, underpinned by a sustained evolution and innovation in production and transportation technologies of both goods and services, has resulted in increased levels of international competition, lower prices, and an ever increasing range of goods and services offered to consumers worldwide. At the same time, these processes have generated increased investment and employment opportunities throughout the world. In sum, globalization has created greater growth opportunities than would otherwise have been the case, while offering the potential to achieve a wider and more equitable distribution of the benefits of such growth among countries and among the less advantaged social groups within countries. That is, globalization offers the potential for enhanced social well-being throughout the world. The two principal manifestations of globalization have been increased capital movements and trade across national boundaries, resulting in markets that are larger, more complex, and more closely integrated than ever before.

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Both have been driven to a great extent by technology and liberalization on an increasingly worldwide scale.

Capital Markets

In particular, the sharp and continuous reductions in the costs of communications and computing established the necessary technological platform for the rapid rise in international capital flows, while the process of liberalization that began with the breakdown of the Bretton Woods system of fixed exchange rates led, after the early 1970s, to a progressive dismantling of capital controls that has resulted in an increasingly, though not yet completely, integrated global capital market. Although there is no doubt that the resulting sharply increased mobility of capital presents important challenges to domestic policymakers in the conduct of monetary and exchange policies, as well as in financialsector supervision, such mobility has resulted in tremendously increased private capital flows to developing countries in general. Indeed, “net private capital flows to developing countries (excluding the Asian newly industrializing economies [NIEs]) averaged about $150 billion a year over 1993–96 and almost hit $200 billion in 1996—nearly a sixfold increase from the average annual inflow over 1983–89.”1 Moreover, the largest proportion of these inflows have been in equity and portfolio investments in recent years, as compared with the predominance of bank lending during the 1970s and early 1980s. The benefits of such increased capital flows are substantial. Using the Latin American region as an example, total investment increased its share of GDP from 19.6 percent in 1990 to 23.0 percent in 1996. Together with exports, which on average increased by 8.3 percent annually in the 1990s, the 6.1 percent average increase in investment fueled economic growth, which has averaged approximately 3.5 percent annually vis-à-vis a very depressed 1.0 percent during the 1980s, while improving the quality of such growth.

World Trade

The evolution of production and transportation technologies has also contributed significantly to the startling growth in world trade during the past three decades. Indeed, the volume of world trade has been growing at an annual rate approximately twice that of the growth of the global economy, which has been expanding at a rate somewhat above 3 percent per year. Such growth has been partially fostered by the improvement in transportation technologies, such as the growth in containerization and multimodal transportation since the 1960s, which together with increased deregulation of the transportation industry, particularly in the United States, resulted in huge productivity gains and sharply reduced shipping costs. At

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the same time, higher-valued manufactured products (compared with commodities) have progressively increased their share in world trade and today represent over 70 percent of the total. This implies that the cost of shipping represents an increasingly lower proportion in the total value of goods traded worldwide, thereby further spurring the growth of trade. Unquestionably, however, the greater proportion of growth in world trade and the increased integration of the world economy have been driven by the liberalization of trade in both goods and services and the resulting lowering of barriers to foreign trade. All this resulted mainly from international agreements to lower tariffs and nontariff barriers under the General Agreement on Tariffs and Trade (GATT), now institutionalized as the WTO, as well as through the relatively recent initial opening of the most heavily protected activities—agriculture and textiles—and the extension of the trade rules to cover services as well as goods. Progress is still required in trade liberalization, however, including reducing the frequent application of “unfair trade laws,” particularly by the largest industrialized economies, as ill-disguised protectionist mechanisms. Another factor that has contributed significantly to trade growth is the proliferation of trade agreements within regional and subregional economic groupings, such as the European Union (EU), the North American Free Trade Agreement (NAFTA) area, Mercosur and the Andean Community in the Western Hemisphere, and APEC in the Far East. As trade barriers have disappeared among neighboring countries with very little prior commercial relations, trade has expanded so significantly between them that in a very short period some of these have become main trading partners. In the Western Hemisphere some examples in recent years are Brazil and Argentina, and Colombia and Venezuela. As tariffs and nontariff barriers continue to fall within and between such regional trading blocs, it is to be expected that intraregional trade flows will continue to increase in the future and capture an increasing proportion of total world trade. The European Union is perhaps the best example of what is possible to achieve through economic and political integration. Beginning with the development of a common market for coal and steel in 1950, and continuing with the adoption of a general common market through the Treaty of Rome in 1957, the EU has evolved progressively into an increasingly integrated economic and political community. Its more recent efforts to harmonize the economic policies of its members have begun to pay off with its decision to adopt the euro as a common currency, which is possibly the next to last step in the process of achieving full economic and political integration of the European economies.

Other Factors in Globalization

In addition to the benefits provided to individual economies by the increased integration of capital markets and the growth in world trade in

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goods and services, there is the increased transfer of technologies derived from foreign direct investment, especially by multinational companies that are undoubtedly one of the “main conduits through which globalization takes place.”2 Although developing economies cannot and should not rely exclusively on such transfers for their technological development, the role of multinational corporations in fostering domestic technological progress should be promoted, including by providing adequate legislation for the protection of intellectual property rights. As for labor markets, it cannot be affirmed that globalization has contributed to greater labor mobility worldwide. On the contrary, it is probable that generating greater growth and employment opportunities through increased trade and investment in the longer term may in fact contribute to lessening pressures for cross-border emigration. This may be not only the case for unskilled workers but also for highly skilled workers who find increasing employment opportunities in the tradable-goods sectors of their economies. Also, it is clear that the forces of globalization may affect the employment situation in certain sectors in both advanced and developing economies as increasing production flexibility shifts output from one country to another, but in the former “the shift in employment away from manufacturing appears largely to reflect the forces of technological progress and capital deepening, rather than international trade pressures,” while in the latter the rise of incomes “helps to provide a growing market for some of the high valued output of the industrial countries.”3 In advanced economies these trends raise issues related to the growing income inequalities between skilled and unskilled labor, while in emerging economies workers worry about the application of protectionist measures by industrialized countries that may result in increased unemployment. In both groups of countries, employment levels will be better sustained in the context of flexible labor markets that encourage mobility while keeping labor costs in line with productivity. Similarly, appropriate investment in human capital is necessary to continuously improve and adapt workers’ skills to the changing economic circumstances of the globalized economy. Globalization and Domestic Policies

Having discarded at the outset that evading globalization would work as a “protective” mechanism, it is also clear that it offers both enormous opportunities and risks. Fortunately, the conditions necessary to benefit from the former are essentially the same as those required to mitigate the latter.

Macroeconomic Policies

At the risk of being repetitive, the importance of strong fiscal and prudent monetary policies cannot be overemphasized as the necessary, though not

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sole, preconditions to benefit from and mitigate the risks of globalization. Indeed, a key lesson derived from the experience of globalization during the 1990s is that its effects “accentuate the benefits of good policies and the cost of bad policies.”4 Macroeconomic stability, reflected especially in low fiscal deficits and inflation, as well as stable exchange rates, promotes an efficient allocation of resources through rational savings and investment decisions based on economic fundamentals. These conditions generate the necessary confidence to promote both domestic and foreign capital investments that encourage growth and, together with trade liberalization, constitute the basic mechanisms for countries to benefit from the process of globalization. Similarly, empirical studies indicate that on average developing countries with lower inflation and fiscal- and current-account deficits—that is, those with sounder macroeconomic policies—tend to exhibit higher rates of growth, and higher rates of convergence with industrialized economies, thereby making evident the principle that sound policies can maximize the potential benefits of globalization while mitigating the associated risks. There are sufficient recent examples of countries whose experiences demonstrate the risks that weak policies entail for medium-sized open economies and the enormous costs associated with the reaction of international capital markets when the latter perceive the existence of such risks. Mexico in 1994–1995 and more recently Thailand, the Philippines, Indonesia, Malaysia, and Korea, where the situation is still extremely unsettled at the time of this writing, provide examples of economies with external imbalances that led to deep economic crises. In the past such macroeconomic disequilibriums were to a great extent “resolved” internally in any given economy through inflation, devaluation, and recession. However, in the context of increased globalization, the consequences of such disequilibriums are sharply and, in some cases, extremely exacerbated by external market forces that can inflict substantial, swift, and harsh punishment on any economy, the smaller and the more open econo mies being most vulnerable. Justifiably or not, recent experience also demonstrates that the economies of countries that the markets perceive as linked to a weak economy, even by geographic proximity or regional association, are also exposed to punishment through contagion effects. This is not an entirely illogical outcome of a crisis in any given country. Indeed, as markets react to such a crisis they tend to take closer looks at risks in other countries, particularly in neighboring areas. If situations are found to be similar to that in the originating country, market participants hedge their bets rapidly, and the crisis situation can spread to the related region, and even beyond, with the further risk of becoming a systemic crisis that feeds on itself. This seems to have been the case in East Asia, where Thailand’s policy weaknesses were found to prevail, to greater or lesser extent, in the

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other countries affected by the crisis. Although these generally had lower external current-account deficits, the other countries nonetheless exhibited similarly important structural weaknesses, for example, in their weakly supervised financial sectors and inflated property markets. Furthermore, the long tradition of government intervention in the development processes of East Asian economies and the extremely close relations between banks, businesses, and, in some cases, governments were seen with increasingly critical eyes by the markets, especially in the context of the relative lack of transparency of information on their financial sectors, including central bank operations. All these factors combined to create the contagion effects that spread the Thai crisis to other countries. On the positive side, post-Mexico experience indicates that after an initial “herd instinct” reaction, capital markets learn to pick out fairly rapidly those economies with sounder fundamentals and to treat them somewhat differentially, although they are rarely unscathed by a crisis. In this respect, the increased openness in providing information to the markets, as promoted in particular by the IMF through its initiative on data dissemination, has contributed substantially to accelerating the markets’ moving along the relevant learning curve and better differentiating among economies. Trade Liberalization

Open trade policies constitute a second set of necessary conditions for participating fruitfully in the globalizing process. In fact, increased trade is typically the first expression of the benefits of globalization in any economy. While all countries can benefit from greater trade openness by allowing them to better exploit their comparative advantages, and to develop their competitive advantages, clearly the potential benefits are proportionately much greater for relatively smaller economies, such as those typical of G-24 membership, with open trade policies that can enlarge their potential markets by multiples, thereby greatly enhancing their growth opportunities. During the past decade or so developing countries have progressively abandoned statist, protectionist, and import substitution policies and adopted more outward-looking and open policies, especially by lowering tariff and nontariff barriers and adopting more flexible exchange rate policies. This policy evolution has resulted in a deepening and diversification of trade among developing countries, especially though not exclusively within regional trading groups. In fact, even as the share of developing countries in world trade increased from 23 to 29 percent between 1985 and 1995, trade among developing countries increased from 31 to 37 percent of their total trade in the same period. These statistics reflect the fact that globalization is not an exclusively “North-South” phenomenon, but that

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much progress has also been achieved in the “South-South” context as well, a fact that will undoubtedly have significant political implications in the future as emerging and developing economies capture increasingly large proportions of world trade and production. Although openness in trade unquestionably increases the risks of contagion effects in crisis situations, an obvious advantage is that it can also help economies resume growth after experiencing economic crises. This was the case of both Mexico and Argentina, which recovered rapidly from the 1994–1995 crisis through export-led economic growth. Financial Liberalization

A third crucial policy element in globalization is the liberalization of domestic financial markets to promote growth through the mobilization of savings and their efficient allocation, while establishing an appropriate framework for the economy to benefit more effectively from the increased global integration of financial markets. The benefits of domestic financial liberalization are fairly evident in the strong positive correlation that exists between economic growth and financial-sector development. However, the negative experience of many economies also underlines the importance of adequately sequencing the process of liberalization, while accompanying it with strengthened prudential regulations and effective supervision of financial sectors to maintain banking soundness. In this respect, a stable macroeconomic environment is a necessary requirement for financial-sector liberalization. Indeed, macroeconomic instability is a principal source of that sector’s vulnerability. “Significant swings in the performance of the real economy and volatile interest rates, exchange rates, asset prices and inflation rates make it difficult for banks to assess accurately the credit and market risks they incur.”5 Additionally, banking-sector weaknesses in particular have either been the cause of economic crises in many countries or contributed to exacerbate them substantially. Thus the importance of strong and well-supervised financial sectors cannot be overemphasized, in both the context of domestic policies and of globalization, if its unavoidable risks are to be adequately mitigated. The soundness of financial sectors entails competent management and well-capitalized banks, appropriately transparent financial information, limitation of the moral hazards involved in the central bank’s function as lender of last resort, and strong, autonomous supervision in the context of an adequate regulatory framework. The last of these conditions is unquestionably the most important, and should aim at “limiting the adverse impact of the official safety net on risk taking and to force banks to internalize the externalities of failures.” 6 The objective of banking supervision “should not be to guarantee the survival of every bank but to make sure that the banking system as a whole remains sound.”7 For this purpose

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banking supervision should aim, inter alia, at proper and timely disclosure of information, enforcement of sound accounting practices (e.g., adoption of international accounting standards), and enforcement of strict rules on capital adequacy and loan classification. In this context, foreign investment in the financial sectors of developing countries should be welcomed to promote competition and help speed the introduction of new technology, the adoption of international accounting standards, and the general modernization of the local financial sector. Unfortunately, too many countries have not paid sufficient attention to the health and adequate supervision of their financial sectors and have paid dearly for their mistakes. Indeed, in the relatively recent past, several economies have suffered banking crises that have cost them more than 15 percent of their GDP and that have been exacerbated by the now predictable reactions of international capital markets. Other Domestic Policies

Although globalization entails a high and increasing degree of international competition, particularly in international trade, it does not involve a zero-sum game but rather a process that can benefit all parties involved. In this context, those economies that have been more effective and successful in inserting themselves in the global market are those that have complemented sound macroeconomic policies, such as those discussed above, with structural policies aimed at improving their “supply-side” efficiency and, thereby, their competitiveness. This involves not only topics such as privatization, which will be commented upon, but other such areas as investment in human resources and increased labor market flexibility; reducing the role of the state in the economy, including through the elimination of unnecessary regulation of many economic activities; development of high-quality public services; and emphasis on the availability of productive infrastructure. For these reforms to be successful they need to be sustainable—a concept that entails not only an economic dimension but also an ecological one—and, even more significantly the human, or social, dimension, which is the only manner of ensuring the reforms’ long-term viability. An example of the beneficial effects of deregulation was mentioned earlier in reference to the sharp reduction of shipping costs derived from the deregulation of transportation, particularly in the United States. A more recent example is related to the power industry, which has been undergoing profound changes that are driven to a great extent by deregulation in many countries. Deregulation’s effects have been surprisingly beneficial: domestic energy prices have fallen and trade in energy has increased as countries have overhauled and simplified their regulatory policies and allowed market forces to work, while simultaneously improving their overall

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competitiveness. Other sectors whose competitiveness has improved from deregulation include port services and infrastructure, air transportation, and water supply. In general, policies aimed at developing or promoting the development of basic infrastructure and adequate public services are particularly important in the context of globalization. This is necessary both to improve basic living conditions and thereby contribute to the development of human capital, as discussed below, and to increase the overall competitiveness of the economy. Indeed, as the forces of economic integration intensify, so do the related trade, capital, and communications flows, which are the principal manifestations of globalization. Adequate infrastructure capacity is needed to support the related increase in these economic flows and to ensure that bottlenecks do not hinder attaining the potential benefits of growth through globalization. Whether such infrastructure in communications, energy, water supply and sanitation, and transportation, among others, is developed directly by the state, or appropriate conditions are created to promote the development by the private sector, is a secondary issue that depends on the fiscal situation of any given economy, its political traditions, and the overall quality of its public expenditures. What is important is that the necessary infrastructure be sustainable, cost-effective, and opportunely available to sustain an economy’s insertion into the globalizing process. Policy Complementarities

In the light of the multiplicity of sound policies, both macroeconomic and structural, that are proposed as necessary for economic development and successful insertion into the globalizing process, an increasing amount of attention, including empirical analysis, is being given to the issue of policy complementarities. This refers to the combination of policies that seem to have been more successful in fostering development, high economic growth, and increasing per capita incomes. A recent empirical study finds that concurrent “progress along a multifaceted set of policy dimensions is more critical than sometimes appears to be thought, especially as the world economy becomes more globalized.”8 This seems to be the case as a result of mutually reinforcing interactions of diverse policies in contributing to economic growth. Indeed the study finds that, individually, policies such as trade openness, stable macroeconomic policies, and small government sectors do not contribute very significantly to economic growth but that “favorable combinations of policies can significantly increase a developing country’s economic growth performance.” These empirical results are intuitively reasonable when looked at from the perspective of globalization. Consider, for example, a country that has

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sound financial policies and a relatively small government sector but that is not open to foreign trade. It is likely that such an economy would not be very attractive for investments by multinational companies interested in producing for export purposes. If such an economy is sufficiently large, some international investments may be forthcoming to supply a large domestic market, but there would likely be little incentive for continuous investments in new production technologies that would contribute to improve the country’s international competitiveness. Clearly, a relatively closed economy will not be in a position to reap the full potential benefits of the process of globalization. In the words of Jahangir Assiz and Robert Wescott: That policy complementarities are becoming more important as the world economy becomes more globalized should not be surprising. International business decisions, such as where to set up an overseas manufacturing plant, how to pay for it, where to sell its products, how much technology to transfer to the plant, and where to source that technology are increasingly interrelated. It is to be expected that policies that hinder any aspect of such an operation may disrupt expansion plans, and by extension, the pace of economic growth. As the forces of globalization continue to increase in the world economy policy, complementarities appear likely to become even more important.9

Role of the State

The nature or characteristics of the role of the state in an economy has implications that go far beyond the issue of globalization and that involve the nature of the social compact in any country, as well as its traditions and decisionmaking processes. Nonetheless, the economic role of the state has an extremely important bearing on how an economy will successfully insert itself into and benefit from the process of globalization. It should be apparent from the previous discussion that the process of globalization is intricately linked with the principles of economic liberalization, which have increasingly gained credence throughout the world. To a certain extent this linkage has been made more evident, and the process of globalization itself has been further accelerated, by the loss of credibility of the socialist ideal of economic development because of the collapse of the former Soviet Union. In turn, these developments have raised important issues over what should be the role of the state under the new paradigm. Globalization, economic liberalization, and the failure of socialism have all contributed to stimulate the reduction of the role of governments in economic activity. Today it is generally recognized that the private sector is usually more efficient than government enterprises in organizing the

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factors of production to produce goods and services. This is certainly the case in general, and examples abound throughout the world of inefficient and/or corrupt management of government enterprises that, even under monopoly conditions, can run persistently large losses and place heavy burdens on government budgets—with correspondingly unfavorable macroeconomic implications. It is not, however, a universal truth; there are also examples, albeit considerably fewer, of both well-run public corporations and inefficient, incompetent, and/or corrupt private entities: for example, the condition of banking sectors in countries that have suffered through significant financial crises. Nonetheless, the overwhelming evidence that the private sector is generally much more efficient than the public sector in productive activities together with pressures imposed on government budgets by the need for fiscal discipline, as well as the trend toward economic liberalization, have provided the necessary impetus for privatizing government-owned enterprises. This applies also to granting concessions to the private sector for the supply of such public services as power, water, health, sanitation, and transportation, and, more recently, even the construction or management of basic economic infrastructure, heretofore almost exclusively in the realm of public-sector activities. Now, as the role of governments in their economies diminish through their withdrawal from productive activities as a result of the combination of the multiple forces of deregulation, economic liberalization, and globalization, the issue arises as to how far these processes should evolve. What should be the new role of the state, at least in its broad economic dimension? As yet there is no uniform opinion or consensus on this issue, but the trend points in the direction of less government—however, strong and highquality government that focuses the economic dimension of its activity on improving its human capital, ensuring the availability of the necessary infrastructure for the economy to be competitive, and creating the necessary conditions to achieve a better balanced distribution of the benefits of economic growth, including those derived from globalization, among its population: that is, government that promotes greater social equity. This implies that the role of the state is increasingly less as an interventionist and less as a producer of goods and services but rather as more policy oriented, providing guidance to and oversight of the economy and regulating it competently and transparently, especially where market mechanisms fail. In sum, its role tends to become more concentrated in activities that generate positive externalities for society, such as greater equality of opportunity and social equity, which would not naturally result from market forces or from the goodwill of individuals. Now, how is this to be achieved without falling once again into the failed promises of socialism? To a great extent, the answers seem to lie in the direction of what are now called “second-generation reforms,” which include “developing efficient, accountable government institutions that

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will guarantee the rule of law and support private sector initiative and activity; and providing the infrastructure and public services that the state is best placed to provide.”10 Within the context of this broad statement, it is necessary to emphasize that “guaranteeing the rule of law” includes the enforcement of an appropriate regulatory environment to ensure competition and equality of opportunity, and that the provision of “public services” must emphasize in particular investment in improving human capital through quality education and health programs. In his remarks at Bordeaux, which were focused on Latin America but which are broadly relevant throughout the developing world, the IMF’s managing director goes on to describe his views on second-generation reforms more explicitly: The first task is to enforce the rule of law and uphold the professionalism and independence of the judicial system—ensuring that there is prompt and equal justice for all, and giving confidence to all members of society that contracts will be enforced, rights will be protected, and property will be secure. . . . For the economy to function smoothly, for the government and its reform program to retain credibility and support, the system must give confidence that justice will be done. The second task is to work energetically toward establishing simpler, more transparent regulatory systems that are equitably enforced—systems that ensure equal access to markets and thus promote equality of economic opportunity; systems that encourage competition, eliminate unnecessary business costs and, thus, promote efficiency and growth. The third task is to improve the quality of public expenditure. This means reducing unproductive expenditure to make room for investment in human capital and basic infrastructure. It also means ensuring that essential public services are provided at reasonable cost, that they reach the intended beneficiaries, and that access to these services is equitable. Finally, it means prioritizing spending programs and increasing their cost effectiveness.11

The focus on human capital in second-generation reforms is particularly critical for any society to reap the potential benefits of globalization. At the same time, it is apparent that the process of globalization has not advanced nearly as rapidly in the formation of human capital and education as it has in other areas. This statement may seem somewhat contradictory when contrasted to the rapid evolution of information technology and the acceleration of worldwide communications through the increasing internationalization of the media, all of which makes available immeasurable volumes of information to the public throughout the world. However, the fact is that educational processes evolve much more slowly. These processes are typically based on family, societal, and state traditions, and pursue the transmission of knowledge and values to the individual to provide the capacity to select, analyze, and interpret the information received and thereby adapt it to the individual’s newly globalized milieu. While both the information and education processes contribute to the overall formation of the individual, one is evolving much more rapidly

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than the other. This can generate an imbalance between education and communication, between knowledge and information, between quality and quantity, and between those who have access to quality education, technology, and information and those who do not. Thus the challenge for the state, as well as for society in general, is to improve the reach, quality, and, in some cases, the quantity of its educational and training processes, so that its population, its corporations, its government, and its society as a whole are better equipped and adapted to deal with the increasingly competitive and constantly changing conditions imposed by globalization. Also implied here is the need to develop appropriate communicational efforts to foster, at the very least, a minimal understanding of basic economic issues and their global interrelations among the population at large, in order to make sustainable the necessary adjustment policies in a context of political stability. Of course, education and communications without adequate nutrition and health are unlikely to be very effective. Hence, the state needs to ensure the existence of, at least, the minimal necessary conditions of social equity, equality, of opportunity, and reasonably sound economic management to satisfy the basic needs of its population, even before it can effectively address the more complex issue of education. The stakes involved in the development of human capital and increased social equity are very high, however. After sustained, arduous, and long-term efforts aimed at economic adjustment, structural reform, and second-generation reforms in any given society, if the benefits of growth and of insertion into the globalizing process do not translate into greater social equity and well-being, it is not at all unlikely that the policy and political pendulum may again begin to swing in another direction and that the very credibility of government in such a society may be called into question. Such possible social reactions, though not atypical, would likely be exacerbated and made more virulent by the very process of globalization as economic imbalances are exacerbated by it. Issues Related to the Process of Globalization

This chapter has so far presented an overview of what is involved in the process of globalization and of the public policies required for countries to benefit from that process. Let us now consider some issues that arise from globalization and that have particular relevance for developing countries in general and for G-24 members in particular.

Regional Surveillance of Macroeconomic Policies

As globalization continues to evolve, and as an increasing number of developing countries and emerging economies participate fruitfully in the

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process, it is clear that the integration of such economies will continue to increase and their interrelations will become more intricate and complex. We have already noted, and other chapters of this book cover in more detail, how the integration of international capital markets has generated contagion effects that can translate the negative consequences of internal disequilibriums from one economy to another, especially though not exclusively in regional contexts. Such contagion effects, which can be extremely onerous even for economies with essentially sound policy stances, derive partially from what could be called capital markets’ myopia, which does not allow them to discern sufficiently, and certainly not sufficiently rapidly, the significant qualitative differences in the policy stances of diverse economies in any given region. Rather, capital markets have tended to react under the influence of what has been called a herd instinct and to lump economies together in the capital markets’ initial reaction to crisis situations. Although as a result of the Mexican crisis some measures were adopted to promote greater differentiation of economies, particularly through the adequate, timely, and transparent provision of economic data to international capital markets, the more recent Asian crisis has shown that these efforts have not advanced enough, and that they may not be sufficient in themselves to insulate economies with essentially sound policies from the contagion effects generated by such markets. Another measure, which was adopted following the Mexican crisis, was the IMF’s decision to intensify and strengthen its surveillance procedures and methodology, with a view to developing “early warning systems” that would provide opportune advice to policymakers and thereby reduce the likelihood of crises. According to published information and comments, in the context of the current Asian crisis the IMF’s strengthened surveillance procedures appear to have been effective and the advice proffered to policymakers opportune and adequate. Apparently the advice was not heeded well enough and the crisis was not avoided or, it appears, even mitigated despite the IMF’s efforts. It seems, therefore, that the time is ripe for developing nations, and particularly emerging economies that are increasingly integrated into the world economy and among themselves, to consider additional mechanisms with which to protect themselves from contagion effects in crisis situations. Following the principle of an ounce of prevention being worth a pound of cure, such mechanisms should aim at avoiding crises rather than reacting to them. This implies that emerging economies should begin to exercise an increasing degree of economic surveillance among themselves, particularly in the context of their regional associations where contagion effects are the strongest, and to exert appropriate degrees of “peer pressure” among associated countries when it is perceived that the policy stance of any given economy is weakening and could lead to potential crises with contagion effects for other associates.

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The idea is to develop mechanisms to amplify the scope of surveillance from the current bilateral IMF-country process to a broader collective regional process in which geographic and cultural proximity, self-interest, and adequate peer pressure may contribute to perform what the IMF’s surveillance procedures have not been able to achieve. This is not suggested as a substitute for the IMF’s surveillance procedures, nor for the necessary continued strengthening of the data dissemination and related initiatives, but rather as a regional complement to the IMF’s surveillance processes that could but need not necessarily count on the IMF’s support. One way to begin progress in the proposed direction is to develop, or strengthen, as the case may be, the coordination of macroeconomic policies in regional forums, which is desirable in itself in the context of increased regional integration and globalization, and which could serve as the platform for the development of regional surveillance mechanisms. In this context, the already lengthy experience accumulated by the EU could provide useful examples for other regions. It goes without saying that implementation of these suggestions implies a high degree of political maturity, for lack of a better term, among the participating authorities of the associated countries, so that constructive criticism of domestic economic policies is not construed as undue interference in the internal affairs of any given country. Moreover, attainment of such a degree of political maturity is also essential if the members of the G-24 are to assume effectively the increasingly rightful position for which they are striving in the overall management and supervision of the globalized world economy. Appropriate Supervision and Regulation of International Players in the Globalized Economy

As globalization progresses in the world economy, to a great extent as a result of the activities of multinational corporations that are “the main force behind worldwide flows of capital, goods and services,”12 it is becoming increasingly apparent that an appropriate degree of international supervision and regulation of those activities is necessary, much as it is necessary in the context of national economies. The case for international supervision and regulation of the financial system has received a substantial amount of attention as a result of the spectacular failures of important international players in recent years, and the systemic implications these failures have had, or could have had. Some progress has been achieved in the sense of improved international exchange of information and cooperation among national supervisory and regulatory authorities under the auspices of the Bank for International Settlements (BIS). Also, studies are now being done on structural changes in international money markets, particularly the role hedge funds may have in

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exacerbating and propagating crisis situations, with a view to determining the possible need to adopt appropriate regulatory actions for these markets. In light of increasing regional cross-border integration of financial institutions, the need for strengthened coordination and cooperation arises as well as in regional contexts, all the more so because of the current Asian crisis that has again shown the importance of maintaining sound financial systems across regional borders to minimize the risks and potential impacts of contagion effects. This is certainly a topic that should be placed on the regular agendas of appropriate regional forums. In addition to the need for strengthened international and regional supervision and cooperation in the financial sphere, another topic that should possibly be on the G-24 agenda is the potential need for regulation of international oligopolistic practices as globalization increases industrial concentration. Although this writer does not have empirical evidence to demonstrate the degree to which international concentration has increased in general, it is apparent that certain industries have significantly increased their concentration in the context of globalization during the past two decades by way of mergers and acquisitions, including the process of privatization. One that comes to mind is the cement industry, producer of one of the basic building blocks of infrastructure, which has been the subject of antitrust investigation on a Europe-wide basis. Other possible examples include pharmaceutical corporations, which are quite intensely concentrated and are known to practice market segmentation involving price differentiation across regions and continents. This is not to suggest that these industries in particular are engaged in international trust activities or that they are the only ones concentrated on a global basis. These are only mentioned as possible examples of the need for appropriate supervision and regulation of antitrust activities internationally, just as there are national and regional regulations (e.g., in the EU) that aim to avoid excessive concentration and trust practices in any given industry. Multilateral Agencies

Although much can and should be done at the national level, as noted elsewhere in this chapter, globalization has also demonstrated an increasing need for appropriate international regulation, particularly in regard to international capital markets. Indeed, experience has shown that even in the context of strong national policies and prudent financial regulations, the magnitude and volatility of capital flows can inflict serious damage on the macroeconomic and monetary situation of any economy, as well as in its real sectors. Like it or not, this implies the need to develop or strengthen the role and capabilities of multilateral financial institutions that are up to

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the task. This chapter has already suggested that some initiatives should be undertaken at the regional level; others need to be undertaken at the global level. This implies strengthening the IMF in the financial sphere and the WTO in the commercial and antitrust sphere. The need to strengthen the role of the IMF is already explicitly addressed in the context of discussions relating to the modification of the Articles of Agreement in order to extend the IMF’s mandate to include the Capital Account, a decision that will need to be accompanied by an adequate strengthening of the financial resources at its disposal. During the recent annual meeting held in Hong Kong it was agreed to increase the IMF’s capital base by 45 percent, a substantially lower proportion than had been proposed by G-24 members. Subsequent events associated with the Asian crisis have demonstrated the shortsightedness of the quota decision, even without taking into account the implications that the possible expansion of the IMF’s role to the Capital Account will have in the former’s resource requirements. Now, even though the largest member of the IMF is currently experiencing political difficulties in obtaining legislative approval for its quota increase, it must be assumed that the U.S. Congress will eventually approve the U.S. administration’s commitment if the United States is to continue exercising the leadership role it plays in global financial regulation. Despite these presumably temporary difficulties, G-24 members should not hesitate to initiate or support, as the case may be, new actions aimed at further increasing the IMF’s resources. In the context of expanding the role of the IMF, appropriate consideration will need to be assigned to the issue of prudential regulations on short-term capital inflows. Such regulations, in tandem with sound economic, financial, and structural policies, have proven effective in helping to mitigate the potentially negative impact of the volatility associated with these capital inflows. Another area that will deserve intensified attention is the development of orderly debt workout procedures at the international level, analogous to those for domestic bankruptcy. These procedures are necessary not only to help mitigate the systemic risks associated with financial crises, such as the current Asian situation, but also to ensure that the burden of the necessary adjustments falls equitably on both debtors and creditors, while minimizing the risks of moral hazard on both groups of actors. In a certain sense, although in a different context, this principle is already being applied by the IMF and the World Bank in the conception and application of the HIPC (Heavily Indebted Poor Countries) Initiative. Finally, these initiatives have to be accompanied by renewed efforts aimed at achieving a more equitable representation of developing and industrialized economies in the governing mechanisms of multilateral institutions, representation that better reflects their relative participation in the world economy. This is particularly important in the IMF, which is being

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called upon to play an increasingly relevant role in the supervision and regulation of the globalized economy. Of course, this also implies that developing countries, in particular G-24 members, must be prepared to assume an increased burden of responsibility, including financial responsibility, as they increase their representation in the relevant governing bodies along with their growing relevance in the world economy. If circumstances demonstrate that a more equitable representation is not politically achievable, the likely outcome will be the development of alternative multilateral mechanisms, perhaps initially on regional bases, in which developing countries have an adequate say in the financial issues that affect them most directly, much as the EU has developed similar mechanisms for its own members. The consequence, of course, would be a relatively lower relevance of the existing multilateral financial agencies with a global reach, namely the IMF and the World Bank. Conclusion

This chapter has attempted to organize and summarize the principal elements involved in economic globalization, which expresses itself in the worldwide integration of national economies through trade, financial flows, technological change, and spillovers, as well as information networks. It has discussed the domestic policies considered necessary for countries to take advantage of the potential benefits of globalization and to mitigate the risks generated by the forces that globalization unleashes. It has also presented a discussion on the economic role of the state under the new paradigm of liberalization and globalization; this discussion emphasizes the importance of the development of human capital for countries and societies to adapt to the continuous process of change implied by globalization. Finally, this chapter has identified some of the main issues of the current international financial agenda that may deserve special attention from the perspective of G-24 member countries. Notes

The author would like to acknowledge the liberal use of information published by the IMF, a recent series of articles on globalization by The Economist, and other published sources, not all of which are explicitly reflected in the chapter’s notes. As stated above, the author’s purpose has been to organize and summarize information and ideas on the process of globalization, rather than writing an original essay on the subject. The author accepts full responsibility for the contents of this chapter, which he hopes will serve a useful purpose in particular for members of the G-24. 1. International Monetary Fund, World Economic Outlook (WEO), May 1997. 2. The Economist, 22 November 1997.

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3. WEO, May 1997. 4. Ibid. 5. IMF Survey, 3 November 1997. 6. Ibid. 7. Ibid. 8. Jahangir Aziz and Robert F. Wescott, “Policy Complementarities and the Washington Consensus,” IMF Working Paper WP/97/118. 9. Ibid. 10. Michel Camdessus, Europe–Latin America Convention, Bordeaux, 20 October 1997. 11. Ibid. 12. The Economist, 22 November 1997.

9 Globalization and Development at the End of the 20th Century: Opportunities, Dilemmas, Tensions Andrés Solimano

The invitation to write a chapter on globalization and development issues by the G-24, the group representing developing countries to international financial institutions, provides an excellent opportunity to reflect on a major issue that has gained much importance in the 1990s and that will be of first relevance in the 21st century: How to seize the opportunities opened by globalization while at the same time managing the tensions and challenges it poses to the global economy and, particularly, developing countries. The chapter starts sketching the evolution of globalization throughout the 20th century, establishing similarities and differences between pre-1914 and late-20th-century globalization patterns. We identify the opportunities for wealth creation provided by globalization, as well as its “side effects” in terms of increased financial and macroeconomic volatility and its impact on inequality and job security. Then, we discuss the role of global financial institutions in coping with globalization and the scope of action for regional and national institutions in a globalized world economy. The chapter closes with concluding remarks. Historical Background

The last decades of the 19th century (say from the 1870s) to the early 20th century (up to 1914) was a period of rapid growth of the global economy based on an expansion of international trade and free capital mobility under the gold standard. This regime came to an end with the disarray brought about by World War I, which in turn was followed by the big inflations and macroeconomic turbulence of the 1920s in several major European economies and, thereafter, by the Great Depression of the 1930s. These events, in turn, radically reshaped prevailing ideas on how to stabilize global and national economies and the role of international trade and 215

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capital movements as engines of growth and prosperity. Global capitalism was seen as an inherently unstable system, prone to either periods of volatility and inflation, as in the 1920s, or to recessionary trends without self-correcting mechanisms that ensure full employment, as was patently demonstrated in the 1930s. A new set of global financial institutions emerged in the mid-1940s, the Bretton Woods institutions (BWI). The International Monetary Fund was given the mandate of ensuring a normal payments system under a system of fixed exchange rates and providing external financing to countries running balance-of-payment deficits. The role of the World Bank was to provide long-term financing for economic reconstruction and development. A period of considerable stability, rapid growth, and prosperity lasted from the late 1940s to the early 1970s; this period, the “golden age of capitalism,” was based on a globally and nationally regulated market economy. This regulated market economy could be defined by a myriad of global institutions in charge of providing stability and development assistance, complemented by national institutions such as the “welfare state” in industrial countries and a “developmentalist state” in developing countries, oriented to ensure social protection and shared growth. The state also was to implement countercyclical macroeconomic policies aimed at maintaining full employment. The golden age ran out of steam in the industrial economies with the two oil price shocks and the ensuing stagflation of the 1970s. Developing countries, in turn, borrowed heavily in the 1970s, a process that led to the debt crisis of the 1980s. The 1990s have seen a correction of large fiscal imbalances, a restoration of macroeconomic stability, and a resumption of growth in Latin America and other developing countries. However, the 1990s have also experienced recurrent financial instability with globally destabilizing features. This has been the case of the Mexican crisis of 1994, the Asian crisis of 1997, and the Russian crisis of 1998. Globalization, boosted by the adoption of market-oriented economic policies in developing countries and transition economies, is being accompanied by substantial financial volatility. Interestingly, the global economy of the late 20th century resembles, in several respects, the pre-1914 liberal economic order in the sense of a more open regime for international trade and high capital mobility. An important difference, however, between pre-1914 and late-20thcentury globalization is that in the former period there were no global institutions aimed at stabilizing the global economy, financing development, setting global rules for international trade in goods and services (i.e., the WTO), and providing a political and diplomatic forum like the United Nations to settle disputes among states and address a host of such global issues as nuclear proliferation, climatic changes, and poverty.

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A key question is to what extent this present global governance structure, largely designed for the economic and political realities of half a century ago (albeit some of them self-reforming along this period), is able to face the complex challenges posed by late-20th-century globalization. The Opportunities of Globalization

The economic order of the late 20th century offers many opportunities to developing countries and other actors in the global economy. The drastic reductions in barriers to international trade have opened the door for export-led growth. In fact, for small- and medium-sized economies with limited internal markets the possibilities for rapid economic growth lie, to a large extent, in production oriented toward international markets. The historical experience of the past three decades shows that countries that have managed to grow at very rapid rates, say at 7 or 8 percent or more per year, have all relied on strong export growth, with exports expanding at a faster rate than GDP. This has been the case for East Asia since the 1960s (up to the current crisis), China since the mid-1970s, Chile since the mid1980s, and others. Globalization creates through export-led expansion the potential for rapid overall output growth, increasing national wealth and contributing to improving living standards in developing countries. Globalization also acts as a disciplinary force for governments that undertake unsustainable economic policies. High fiscal deficits and unsound financial policies that lead to inflationary pressures, current-account deficits, and/or high real interest rates sooner or later tend to be penalized by international investors and global capital markets. In addition, longterm capital formation (both foreign and national) is particularly averse to instability and the perception of policy reversals. The room for populist and/or unsustainable policies is much narrower in a globalized world. Another benefit of globalization is the access to a wide variety of consumption goods, new technologies, and knowledge. Globalization allows the access to ideas and international best practices in different fields and realms, for example, new product designs, investment projects, production technologies, or managerial practices. There can even be a certain set of institutions that has proved successful in other places and eventually becomes a model for society in general. Of course, the mere acquisition or imitation of foreign products, technologies, or foreign social models by local conditions, with all their specificities and idiosyncratic features, is not a guarantee of success. It is just a potential benefit derived from broadening the set of choices open to the participants of the global economy.

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Tensions and Dilemmas of Globalization

As globalization opens opportunities it also poses tensions and dilemmas to countries integrated into the world economy. One tension is associated with the fact that in a more interdependent and interlinked world economy any adverse global or regional shock, for example, the Asian crisis of 1997–1998, is rapidly propagated in other economies. The transmission channels at work can be a decline in the import volumes and/or changes in the real price of commodities (e.g., oil, copper, timber). Economies that depend heavily on a few main commodities as their main source of export earnings and fiscal revenues can be hit hard by these shocks. This has been the case of Mexico, Indonesia, Ecuador, Venezuela, and Russia, with the drop in oil prices, and Chile, with the decline in copper prices. Another transmission mechanism is asset markets. Highly integrated financial markets tend to transmit global, regional, or local shocks much more rapidly than in past decades when financial markets were less integrated. Portfolio shifts affect exchange rates, interest rates, and economic activity. Because the volumes of financial intermediation and currency transactions are enormous nowadays, shocks can be greatly amplified in more or less synchronized fashion, with destabilizing effects on many economies. This source of financial volatility was largely absent in the world of the 1950s, 1960s, and early 1970s when multilateral lending, aid, and foreign direct investment dominated global capital movements. There is ample empirical evidence showing that uncertainty and volatility penalize capital formation (and productivity growth), with adverse effects on economic growth. Thus instability and volatility can be ultimately viewed as a tax on growth and prosperity. In many instances this instability originates abroad. However, the quality of the domestic policy response in the face of adverse external shocks matters. The nature and timing of domestic policy response can soften or increase the impact of these shocks. Another tension of globalization lies in its social effects. Because globalization is often associated with increased instability of output and employment, this affects, among other things, job security. Since labor income is the main source of earnings for the majority of the population under capitalism, job insecurity is socially disruptive and strains the fabric of society. In addition, flexibility in labor markets required to compete successfully in international markets tends to erode the long-term work and personal relationships between firms and employees, workers and managers that traditionally give a sense of security to people. Another open discussion is whether foreign trade and globalization narrow or widen income disparities. Traditional trade theories suggesting factor price equalization across countries seem of little relevance in a world of large per capita income

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differentials (e.g., between sub-Saharan Africa and the OECD); moreover, convergence in income levels (per person) is, at least, very weak across regions and nations. In addition, globalization gives a premium to people with sophisticated skills, high levels of education, and entrepreneurial traits. These are people better equipped to survive and succeed in the more competitive world brought about by globalization. The mirror image of this is that unskilled labor, uneducated workers, and marginalized populations are likely to benefit less in a more competitive world economy. Thus income and wealth inequality can be amplified, underscoring the need for public policy to correct these inegalitarian trends. Another criticism of globalization (fair or unfair) is that globalization tends to transmit certain cultural patterns of large countries that reduce cultural diversity and, eventually, national identity. Institutional Challenges of Globalization

The institutional architecture of the late 20th century is facing important challenges from globalization. Let us mention some of them. First, it is increasingly recognized today that the maintenance of global financial stability is becoming a very complex task. Capital moves very fast across national boundaries, responding to changes in relative asset returns, flows of information about investment opportunities, and changes in national economic policies. Traditional instruments of monetary and financial control are, therefore, less effective in this setting. Second, as the Mexican, Asian, and Russian crises show, the magnitude of current external imbalances to be financed (and the outstanding financial liabilities to be served) in crisis situations are of such magnitude that they strain (or even exceed) the existing resources available from the IMF and other multinational lending institutions, which have to quickly prepare emergency loans of an unprecedented size. Rescue packages of $10, $20, or $30 billion (or even more) for countries, whether before or after speculative attacks on their currencies, are not uncommon nowadays. Third, international financial institutions (IFIs) have serious problems in anticipating macroeconomic and financial crises. Moreover, when the crises take place and the IFIs come with rescue packages the latter create a moral hazard problem by implicitly giving incentives to market participants for excessive risk taking in the anticipation of future bailouts. Fourth, the exact dividing lines between balance-of-payment financing (the realm of the IMF) and development lending (the scope of multilateral development banks) have become less clear. This was already the case in the 1980s when both institutions started to lend in tandem for balance-ofpayment support as private financing dried up as a consequence of the debt

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crisis. Again, in the 1990s, meeting the large external financial needs associated with the Mexican, Asian, and Russian crises requires a combination of balance-of-payment and development financing. Some institutional failures are also market failures. For example, the failure to anticipate a financial crisis affects not only public multilateral institutions but also market participants and international private risk-grading agencies. (The latter even tend to aggravate a confidence crisis when they downgrade countries in the midst of a crisis.) Moreover, the costs of financial crises are large and affect creditors as well. Relentless lending behavior is costly even with massive rescue packages. In addition, as the current Russian crisis shows, the effects of letting only the market to arrange crisis situations without public intervention can be very disruptive. Coming back to the institutional issue, a strategic issue is how to manage the negative side effects of globalization, particularly the exacerbation of volatility at the national and international level. This is a complex subject that is under intense discussion now, although some observations are in order here. First, there is a need to recognize that free trade and financial integration, two key dimensions of globalization, are different in terms of their respective contribution to economic stability, growth, and social welfare. The crises of the 1990s show that the volatility of short-term capital flows introduces serious volatility in real exchange rates and real interest rates, affecting adversely the real side of the economy (e.g., trade flows investment, output, employment). The implications of this volatility for full capitalaccount convertibility, ranging from liberalization of foreign directinvestment regimes (often less volatile) to liberalization of short-term capital flows (generally more volatile and unpredictable), are being discussed. Second, there is a need to strengthen macroeconomic policy consultation and coordination among emerging market economies that suffer from exacerbated volatility. There is no equivalent of the G-7 at the level of developing countries and transition economies. Third, it is necessary to enforce the Basel Capital Accord of 1998, signed by over 100 countries, that recommends, among others, core principles of bank lending, reserves, and transparency. This accord should be complemented by appropriate mechanisms of bank surveillance and reporting of relevant information for both banks and corporations. Fourth, there is need for a clear definition of the resources available to the IFIs (particularly the IMF) to enable them to perform their role when the financial needs of member countries have increased enormously. Fifth, it is necessary to establish clear exit, liquidation, and bankruptcy rules in countries affected by liquidity or solvency crises. The rules must be known and accepted by debtors and creditors alike. Last, but not least, there has to be a fresh look at the content of the matrix of policy dialogue and, conditionally, of the international financial

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institutions that suit the era of globalization. This need covers a careful consideration of the degree of fiscal austerity in adjustment programs and the role of sound domestic banking systems in preserving macroeconomic stability for issues of transparency, governance, and conflict management mechanisms. The Other Side of Global Governnance: Regional and National Institutions

Global problems require a mix of global, regional, and national responses. At the institutional level, for developing countries globalization has been accompanied by a double development: the emergence of those outside the BWI as relevant actors, both in terms of volume of financing and policy advice, and of regional development institutions (e.g., Inter-American Development Bank, European Bank for Reconstruction and Development, African Development Bank, Asian Development Bank), as well as a reduced role for national governments in conducting autonomous economic policies. Regional institutions often have informational advantages over global institutions about regional economic, political, and cultural realities. In addition, there is greater country representation for developing countries on the most important decisionmaking bodies (i.e., board of governors and boards of directors) than in global institutions. In contrast, regional development institutions are less exposed to global practices and knowledge than are global institutions. The nation-states are still of decisive importance in spite of their reduced direct economic effectiveness in a globalized world. In fact, regional and global institutions are ultimately “owned” by national governments: in other words, the institutions are the agents that implement the mandates of the principals (national governments). Of course, these mandates are filtered through the bureaucratic structures of the regional and global institutions and (at least in the IFIs) reflect the respective voting power of individual countries—in turn, a direct function of the countries’ economic importance in the world or regional economy. Issues of representation, effectiveness, and implementation of mandates of developing countries (a heterogeneous group) are at the core of effective global and regional governance. Conclusion

This chapter has reviewed opportunities to developing countries opened by globalization but also identifies the dilemmas and tensions it poses. The main opportunities of globalization for developing countries lie in the potential for wealth creation through export-led growth and the benefits

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of expanded international trade of goods and services, and access to new technologies, ideas, and institutional designs in the global marketplace. However, globalization also brings problems and tensions that need to be managed in appropriate ways. Global business cycles give rise to considerable macroeconomic volatility at the national level. Of course, volatility has been observed for a long while in developing countries but has become more acute in late-20th-century globalization. Moreover, financial vulnerability is a very serious problem of globalization because highly integrated financial markets swiftly transmit across countries financial shocks and changes in confidence levels that affect exchange rates, interest rates, asset prices, and, ultimately, economic activity. The effect of globalization on income distribution and social differentiation is another area of policy concern: globalization, along with technological progress, might exacerbate the instability of employment and, eventually, widen income disparities both within and across countries. Also discussed was the role of global and regional financial institutions in dealing with volatility associated with globalization, underscoring such issues as the size of rescue packages to prevent financial crises; the difficulties of anticipating such crises; the need to distinguish between free trade and full capital mobility as different dimensions of globalization; and the necessity of complementing the traditional emphasis on fiscal austerity with financial regulation of the banking system, good governance, and transparency. Finally, a theme that deserves further attention is the need to strike a proper balance among global, regional, and national institutional responses to the volatility accompanying globalization. Note

The views expressed in this chapter are the authors and do not necessarily reflect those of the World Bank, with which he is affiliated.

10 New Capital Flows and Emerging Markets Ariel Buira

Capital flows to emerging market economies in the 1990s have been an important policy issue for the international economy. The topic involves many issues, such as what forces drive emerging market economies toward increased integration with international capital markets; the cost and benefits of capital inflows, especially, the problems of volatility of capital; the role of international monetary cooperation in this new environment of globalized markets; and, in particular, the role of international financial institutions. The first section of this chapter provides a brief description of the stylized facts on financial market integration in the 1990s. In the second section the internal and external forces inducing the capital flows to emerging markets are analyzed. The third section discusses the benefits and costs of financial market integration and the main policy challenges faced by the emerging market economies’ recipients of the capital flows. The fourth section considers the macroeconomic consequences of capital inflows. The fifth section explores the options open to emerging market economies for coping with global financial markets and the improvements required in the institutional framework of international monetary cooperation to reduce the volatility of open and integrated capital markets.

Background

Stylized Facts on Financial Market Integration in the 1990s

For many years after World War II, official capital flows and foreign direct investment were the only sources of foreign capital available to developing countries. It was not until the early 1970s that private capital flows to emerging markets resumed.1 The oil price shocks of 1973–1974 and 1979– 1980 set the stage for the massive expansion in sovereign lending that took 223

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place during these years. From 1973 to 1982, many developing countries in Asia and Latin America received large capital flows closely associated with the recycling of oil revenues. Bank loans were the main instruments used for the intermediation of these flows. In addition to the surge in oil revenues, there were other forces at work that prompted the substitution of official flows for private flows. Among the most important were the following:

1. The insufficient capital resources of the World Bank and the regional development banks that did not allow the banks to meet the growing demand for credit of developing countries 2. The political difficulties in industrial countries in obtaining legislative approval for increases in the capital of international financial institutions 3. The policy of the United States of seeking to “graduate” middleincome developing countries’ major borrowers at the World Bank and regional banks and send the borrowers to international capital markets 4. The aversion of developing countries toward the supervision and conditionality attached to the credits and bureaucratic practices of international financial institutions

The volume of capital flows to developing countries was highly uneven. An initial surge in the 1973–1982 period ($163 billion) was followed by a slowdown during the rest of the 1980s ($103 billion), and, as the debts of major borrowers were rescheduled, a renewed surge took place in the 1990s.

Resumption of Capital Inflows to Emerging Markets

The debt crisis that erupted in mid-1982 brought to an abrupt halt the inflow of private capital to emerging market countries and, consequently, led to a sharp deterioration in the macroeconomic performance of this group of countries, particularly in Latin America. The 1980s have been “the lost decade” for many developing countries. In this context, the economic situation faced by the heavily indebted countries up to the late 1980s provoked considerable pessimism about how rapidly these countries would be able to reestablish their access to international financial markets. Despite several years of adjustment effort and concerted lending, the general feeling was that it would take a number of years before access to markets on voluntary terms was restored. The 1980s provide an example of the cost to countries of losing access to international capital markets. The sharp deterioration in the macroeconomic performance of many emerging market economies that resulted from the net negative transfer of capital as a result of the debt crisis attests

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to the importance of financial flows. For example, the average rate of growth for all emerging markets fell from roughly 4.5 percent in the period 1977–1981 to approximately 1.5 percent in 1982 and 1983. Moreover, in those emerging markets that experienced debt-servicing difficulties, their rate of growth fell from roughly 4 percent per annum from 1977 to 1981 to –1 percent per annum in 1982 and 1983. In addition, inflation, reflecting depreciation of the currency, accelerated in those countries that experienced debt-servicing difficulties from approximately 35 percent per annum from 1977 to 1981 to 58 percent in 1982–1984. On top of this, the external debt position of many of the heavily indebted emerging market countries deteriorated sharply when compared with their position in the early 1970s. For example, the ratio of external debt to export of goods and services for heavily indebted emerging market countries with debt-servicing difficulties shot up from 182 percent in 1981, to 236 percent at the end of 1983, and to 375 percent in 1986. Also, the ratio of external debt-service payments to export of goods and services for these countries rose from 32 percent in 1981 to 44 percent by 1986. Despite the pessimism prevalent during the 1980s, following Mexico’s debt-rescheduling agreement in July 1989 capital flows to emerging markets resumed, and in 1990–1996 net private flows soared to over $1 trillion, more than seven times the amount recorded in 1973–1981. Moreover, net private flows during 1990–1996 were over nine times as large as net external borrowing from official creditors. In fact, private capital inflows overall rose from the equivalent of 3 percent of domestic investment in emerging market countries in 1990 to 13 percent in 1996. Geographically, the distribution of these flows has been uneven. Asia received the largest amount, 40 percent, and Latin American countries obtained 30 percent. In contrast, only 8 percent of the flows went to economies in transition; around 5 percent went to African countries; and the rest went to countries in the Middle East and Europe.2 Furthermore, the composition of the net flows also changed dramatically with respect to the 1978–1982 period. While the syndicated bank loan was the main instrument associated with capital flows during those years, portfolio investment (particularly bonds) and foreign direct investment have been the most important instruments in the 1990s. Indeed, the share of foreign direct investment reached 40 percent of total net private capital flows during the period 1990–1996, and portfolio flows accounted for 39 percent. The most significant change was in portfolio equity flows, which rose from $1 billion (3 percent of total net private capital flows) in 1990 to $16 billion (7 percent of total net private flows) in 1996. The 1990s have also witnessed an expanding participation of emerging market institutions in major financial centers, in part related to the more active management of the growing foreign exchange reserves of these countries.

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Factors Behind Capital Flows and Renewed Market Access in the 1990s

The large scale of capital flows to emerging markets in the 1990s has led to substantial research that seeks to identify the forces driving these flows.3 Such research has typically divided the factors influencing capital flows into external and domestic factors. External factors encompass both structural and cyclical developments in international (mainly mature) financial markets that lead investors to diversify their portfolios internationally and seek higher yields in emerging markets. Domestic factors refer to the macroeconomic and structural policies in emerging markets, as well as political and other noneconomic developments, that have increased their perceived creditworthiness. Structural Changes in International Financial Markets

The scale and composition of the capital flows to emerging markets in the 1990s has been influenced by ongoing structural changes in international financial markets. The most important of these has been the liberalization of financial markets and capital-account transactions in both industrial and emerging market economies. As domestic and international financial markets become integrated, it is increasingly difficult to keep domestic financial market conditions isolated from developments in international markets. For example, the growing importance of portfolio flows (both bond and equity) in the 1990s has reflected two other fundamental structural changes in international financial markets, namely, the role of institutional investors and securitization. Institutional investors, including mutual funds, insurance companies, pension funds, and, more recently, hedge funds have become important holders of emerging market securities. These investors’ participation in such markets has been driven by the desire both to increase the overall return on their portfolios and to diversify the risks associated with these portfolios. Securitization has involved a greater use of debt and equity markets. The substitution of direct for indirect instruments has been driven in part by the lower relative cost of borrowing on securities markets by the more creditworthy borrowers (which often have a higher credit rating than banks). Additionally, the growing importance of derivative products has enabled portfolio managers (particularly from institutional investors) to hedge or increase the products’ exposure to certain types of asset price risks. The revolution in information technologies has affected flows to emerging markets by increasing the efficiency of global securities markets in the issuance of bond and equity issues, by facilitating the syndication of bank loans, and by providing emerging market borrowers and investors with derivative products with which to manage exchange, interest, and credit risks.

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In summary, capital flows to emerging markets in the 1990s take place in a very different environment than that of the 1970s. Structural developments have created incentives for international investors, especially institutional investors, to invest in a growing range of instruments issued by public and private borrowers from an expanding set of emerging markets. Domestic Factors in Emerging Markets

During the 1990s emerging market economies have striven to improve their macroeconomic management and to effect deep structural changes in their economies. This stands in sharp contrast to the policies followed by many middle-income developing countries up to the debt crisis in 1982. As a consequence, the economic performance has improved considerably with respect to the period between the emergence of the debt crisis in 1982 and the initiation of the Brady Plan in 1989. Fiscal deficits for emerging market countries that experienced debt-servicing difficulties fell from an average of 6 percent of GDP in 1983–1989 to 3 percent of GDP in 1990– 1996, partly as a result of the reduction of debt service. Although less progress was initially made in containing inflation, with the average rate for countries with debt-servicing difficulties rising from 77 percent per annum in 1979–1989 to 177 percent per annum in 1990– 1995, the inflation rate of this group fell to 36 percent in 1995 and 19 percent in 1996. In contrast, the real growth rate of output for the countries with debt-servicing difficulties rose from 2.2 percent per annum in 1979– 1989 to over 6.0 percent in 1990–1996. Similarly, export of goods and services of this group of countries with debt-servicing problems declined from 162 percent in 1990 to 128 percent in 1996 despite the rapid growth that had taken place in their external debt. Moreover, the average ratio of external debt to GDP fell from 54 percent in 1990 to 37 percent in 1996. The improved economic performance of many emerging market countries played a key role in enhancing their access to international financial markets. In addition, the extensive privatizations they have undertaken and, more generally, the opening of their economies to international trade and capital flows have also contributed to their greater access to capital markets.

Stabilization in Industrial Countries

The improved environment in industrial countries with respect to inflation and interest rates during the 1990s has prompted outflows of capital in search of the higher yields provided by emerging markets. Recall that inflation in the major industrial countries during the period between 1990 and 1996 declined from an average rate of slightly above 4 percent to less than 2 percent. As a consequence, nominal short- and long-term interest rates also declined. Short-term interest rates in the major industrial countries

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fell from an average of 7.3 percent in 1987–1990 to 4.3 percent in 1994– 1996. Similarly, long-term interest rates fell from 8 to 6.3 percent during the same period. These declines in nominal rates have exerted a major influence on the volume of capital flows to emerging markets. Advantages and Risks of Financial Market Integration

Benefits of Financial Integration

As in the case of free trade, economic theory indicates that free capital movements facilitate a more efficient global allocation of resources and help channel savings into their most productive uses, thus increasing economic growth and welfare. For any country the benefit of the access of domestic residents to foreign capital is an increase in the potential pool of investable funds. For the world economy, open capital accounts support the multilateral trading system by broadening the channels through which developed and developing countries alike can finance trade and investment and attain higher risk diversification, and thereby provide investors with a potential to achieve higher risk-adjusted rates of returns. Access to an integrated pool of global savings means cheaper financing for governments and domestic corporations. Moreover, the new financial technologies that accompany the entry of foreign participants into domestic financial markets can upgrade the entire financial system. Residents of countries that permit portfolio investment abroad can hold more diversified, less risky portfolios. These are benefits that every country may enjoy as a result of its access to the international capital markets. However, financial market integration imposes severe limits and restrictions on discretion in the conduct of economic policy by domestic authorities. Monetary authorities have to recognize their effective loss of autonomy in a global economic environment. Policymakers must pay due regard to market perceptions and work with markets, and not against them, to create a synergy between authorities and markets. Equilibrium in the domestic financial market is nowadays a necessary condition (though not a sufficient one) to avoid market disturbances. Basic disequilibriums increase the risk that market pressures will aggravate distrubances through, for instance, higher interest rates or exchange rate adjustments, and consequently make the return to the equilibrium path more difficult. Risks and Costs of Financial lntegration

International capital flows tend to be highly sensitive to the conduct of macroeconomic policies and to the perceived soundness of the domestic banking system and to unforeseen economic and political developments.4

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In this way, market forces exert a disciplinary influence on countries’ macroeconomic policies that tends to improve overall economic performance by rewarding good and penalizing bad policies. Moreover, developments in financial markets have the ability to influence and modify national economic policies, to impose exchange rate adjustments and even make governments abandon exchange rate regimes, to increase financial asset volatility, to worsen an economic disequilibrium (which could end in an inflationary process or economic recessions), and to transmit pressures from one market to another, consequently increasing systemic risks. Certainly globalization implies a shift of power from governments to markets, the shift being reflected in a reduced autonomy in the formulation of economic policy. However, financial markets are not always right. Sometimes capital inflows might be too large, exceeding any reasonable notion of the absorptive capacity of a country, and sometimes they may be sustained for too long. On occasion, markets tend to react late; but when they do react they do it very fast, and sometimes excessively. Some spillovers are rational and efficient: for instance, when a country devalues its currency the equilibrium exchange rate for competitors may also depreciate. But often contagion effects seem to be unwarranted. Market overreactions sometimes take the form of contagion effects—spillovers from a crisis in one market to other related markets without consideration of differences between countries. Perfect markets with full information and zero transaction costs do not exist. Information is incomplete, there is herd behavior, and sometimes investors take decisions based on an inaccurate appraisal of the underlying economic situation. Contagion effects might result in attacks that become self-fulfilling prophecies: for instance, the banking system might weaken in the face of an attack that forces a devaluation and higher interest rates. No economy can easily weather a panicked withdrawal of confidence, leading to a massive devaluation of the currency, especially if the money was flowing in just weeks before. Capital inflows and commercial bank lending tend to be markedly procyclical in responding to macroeconomic conditions in both capitalexporting and capital-importing countries. Capital comes most readily to emerging markets when economic and business prospects are good, while capital flows tend to decline when the economy slows down or when problems or uncertainties of any kind appear on the horizon. Thus, capital markets themselves tend to undermine the creditworthiness of countries. As the Bank for International Settlements (BIS) stated some time ago: To put this view into perspective, it may be useful to imagine what would happen in a national context if during the recession banks were suddenly to cut off the flow of new credits to the corporate sector and to begin

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closing off existing short term credit lines. The inevitable result will be a financial collapse which will frighten even soundly managed firms, including banks. . . . Such a financial collapse . . . would not permit any easy inference with respect to the quality or the pattern of bank lending and of corporate investment before the outbreak of the crisis, whereas the conclusion could safely be drawn that something had gone seriously wrong with the macroeconomic management of the economy.5

Market behavior is often characterized by information asymmetries and contagion effects. Country risk analysis, which is far from perfect, is often dominated by “herding” behavior. Recent episodes of financial market turbulence illustrate that a country might lose its creditworthiness overnight, leaving authorities little time to react. In some cases, the sudden loss of creditworthiness may be unjustified. Countries may face abrupt changes in the cost and availability of financing or financial shocks, which trigger sudden shifts in market sentiment and create a strong need for emergency financing. As the market liquidity dries up the country will face excessive adjustment costs. Moreover, as we have seen repeatedly in Latin America and more recently in Asia, there is a tendency to evaluate a country’s creditworthiness as a function of its regional location or stage of development rather than its own merits. When a country in a certain group experiences payment difficulties, markets often tend to suspend new credits to all countries in the same region or with similar characteristics. In many cases the process of restoring creditworthiness is unduly delayed. Investors hold back and wait for the recovery of the country in question, thus making recovery more protracted and uncertain. The official agencies regulating banks and extending official credit, as well as the rating agencies, also play an important role, but, being cautious, may wait to see the compliance with the program for a period of maybe a year or more before revising their appraisal. The bandwagon effects, which abruptly reduce liquidity across the board, can produce harmful effects on recipient countries and have a destabilizing impact on the international monetary system. A major player in financial markets, George Soros, has argued that the private sector is ill suited to allocate international credit.6 It provides either too little or too much; it does not have the information with which to form a balanced judgment; and it is not concerned with maintaining macroeconomic balance in the borrowing countries. Its goals are to maximize profit and minimize risk, making it move in a herd-like fashion in both directions. Additionally, Soros considers that given the uneven distribution of savings and investment opportunities, there is an obvious need for international capital movements. But because the private sector is notoriously inefficient in the international allocation of credit, he believes that international capital movements need to be supervised and the allocation of

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credit regulated by an international authority. In this context, Soros proposes setting up an international credit insurance corporation as a sister institution of the IMF. This new authority would guarantee international loans for a modest fee. Borrowing countries would be obliged to provide data on all borrowings, public or private, insured or not. This would enable the authority to set a ceiling on the amounts it is willing to insure. This would seem to go against conventional wisdom. How can bureaucrats know better than those who take risks for their own account? The answer, Soros points out, is that the technocrats running the proposed international authority would be charged with maintaining macroeconomic balance, while the technocrats in charge of banks would only be guided by profit considerations. Macroeconomic Consequences of Capital Inflows

The surplus in the balance of payments due to capital inflows imposes on a country difficult decisions of economic policy. In the case of a country with a fixed or predetermined exchange rate, the country faces the dilemma of whether to sterilize the monetary expansion resulting from the surplus in the balance of payments or to allow the monetary aggregates to grow, thus providing room for an expansion in the demand for goods and services and to accommodate an increase in the demand for money. A complete sterilization of the monetary expansion implies a total reexport of such capital through the increase in the international reserves of the central bank. The consequence of adopting such a policy is, therefore, that the incoming foreign capital cannot be used to supplement investment. Moreover, this policy leads to some type of inequity. It implies that the additional purchasing power at the disposal of those that have access to foreign capital is subtracted from other participants in the economy. If capital inflows are to be used to increase the productive capacity of the economy, at least part of them must be monetized. Such monetization tends to increase expenditure, including in imports. It is the mechanism by which the country is able to obtain real resources from the rest of the world, such as machinery and equipment, commodities, intermediate products, and other goods produced in foreign countries. Partial monetization of capital inflows also helps reduce domestic interest rates, implying a direct benefit for public- and private-sector debtors. However, there are good reasons to conduct partial sterilization of capital inflows. First of all, one has to consider that foreign investments can be reverted in the future. Therefore, it is convenient to accumulate sufficient international reserves to confront probable capital outflows. Moreover, if capital inflows are very large and not sterilized at all, an excessive increase in aggregate demand will occur, producing unacceptable inflationary pressures.

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In general, capital inflows produce, in a smaller or greater degree, these macroeconomic effects. Capital inflows increase aggregate demand; part of them necessarily will go toward investment and the other part to consumption. They generate a deficit in the current account, they produce an appreciation of the real exchange rate and downward pressure in domestic interest rates, and probably also contribute to a reduction in domestic savings.7 Capital inflows are closely linked to a real exchange rate appreciation because that is precisely the way in which the economy absorbs the exante surplus in the balance of payments that would be present with the initial level of the real exchange rate. The appreciation of the real exchange rate will occur regardless of the exchange regime in place. Under a fixed exchange rate regime or a preannounced depreciation, the phenomenon presents itself through the monetization of the capital inflows that produces an increase in domestic prices. Under flexible exchange rates the nominal exchange rate appreciates. In the case of an exchange rate that responds to market conditions moving within a band, the appreciation of the real exchange rate would be effected through the combination of the two aforementioned mechanisms, that is, prices and nominal appreciation. Once the real appreciation takes place, this will produce an increase in the demand for net imports. The second macroeconomic effect of capital inflows over domestic expenditures is derived from the flexibilization of the budget constraint in the economy. This greater flexibility in the budget constraint tends to produce a substitution of domestic savings for external savings, raising the effective cost of external capital. Moreover, since expectations improve with the new macroeconomic environment that produces capital inflows, that will tend to increase consumption in relation to current income. Such an impact on consumption will affect expenditure in domestic as well as in imported goods. The amount of real appreciation that the economy can manage will depend, of course, on the causes of the inflows and therefore on the perceived permanence and variability of the capital inflows. For example, if the inflows are a once-and-for-all phenomenon, and if the capital market is not perfect, it would be convenient to sterilize the greater part, trying in this way to minimize its effects on the real exchange rate. The real exchange rate tends to have a greater flexibility to appreciate than to depreciate, as a result of certain downward inflexibility of the nominal prices of the goods and services in the nontradable sectors, including salaries. Alternatively, if capital inflows are more of a permanent nature, some appreciation of the real exchange rate will be inevitable, but what will have to be assessed is the magnitude of such inflows through time.8 Generally, capital inflows reflect an increased demand for domestic assets, both real and financial, in response to confidence in the economic

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management leading to attractive prospective yields of such assets. Within these dynamics, capital inflows may be bunched at the beginning and later on reach a lower and more stable flow. This bunching of capital inflows at the beginning of a stabilization process or the lack of uniformity over time of the flow of these resources can reflect an increase in the stock demand for assets in the country. In the short run, this is manifested as a greater flow of capital that later on is followed by smaller inflows as the economy approaches the desired level of such assets. This phenomenon could produce an initial appreciation of the real exchange rate, whose magnitude would have undesirable results due to the rate’s effects on production and on imports and exports. In this context of variable capital inflows, in which they first reach a high level and subsequently taper off, the difficulty posed by the potential disequilibriums arises from the initial increase in the price of nontradable goods in relation to tradable goods. This appreciation of the real exchange rate is reflected in an increase in the demand for importable goods and discourages the supply of exportable goods. However, when capital inflows decline and there is a certain downward rigidity in the nominal prices of the nontradable goods, it is difficult for the real exchange rate to return to an equilibrium level and, consequently, for the quantity demanded of importable goods and supply of exportable goods to adjust to a level consistent with the lower inflow of capital. In the absence of a rundown of international reserves, if there is no financing there can be no deficit in the current account of the balance of payments. Nevertheless, as indicated, one has to recognize that capital inflows produce an appreciation of the real exchange rate. The a posteriori absence of financing or the lower level of capital inflows imply, ceteris paribus, higher interest rates in order to obtain a deficit on current account that is consistent with the financing available. These rates affect aggregate demand, production, and the real exchange rate. The persistence of high real interest rates will depend on the sensitivity of domestic expenditure to this variable; inasmuch as domestic expenditure is reduced by higher interest rates, it contributes to a deceleration on the prices of the nontradables. Gradually the disequilibrium in the balance of payments and the level of the interest rates will diminish, and the real exchange rate may depreciate. The viability of a gradual adjustment process to a lower availability of external resources will depend, to a large extent, on the amount of international reserves in comparison with the size of the disequilibrium and on the time required to eliminate it. If international reserves are perceived by economic agents as sufficient to finance a transition from one equilibrium to another, one should not expect a balance-of-payment crisis. In contrast, if economic agents consider that reserves are not sufficient, both the exchange market and the money market would be subject to important pressures.

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Actions Required to Deal with Global Financial Market Volatility

What can be done to minimize the risks posed by free markets that occasionally burden the economy with inappropriate shocks but, at the same time, continue to reap the benefits offered by the system? As economic orthodoxy would dictate, there are several preconditions that countries must meet to minimize the risks of volatile capital movements that are well understood and uncontroversial. Sound economic policies need to be in place in order to try to avoid sudden capital flow reversals; the structure of the economy should be solid in institutional terms, including a sound domestic financial system; and, in general, the policy framework should be geared to minimizing its vulnerability to sudden changes in market sentiment. However, events in the 1990s have shown that even countries that meet all these preconditions may be subject to speculative attacks on their currencies. The experience during the European Exchange Rate Mechanism crisis in 1992 and during the recent turmoil in financial markets in Asia shows that even countries that have very solid fundamentals are subject to market overreactions. In this sense, there is a need to develop ways and means of protecting countries from the occasional excesses of the market. Three general lines of action can be devised to try to counteract the impact of market overreaction on financial markets in developing countries: • Actions to limit the free flow of resources, whether market-based or administratively controlled. In this category fall all measures adopted to discourage capital inflows (outflows) and that are generically referred to as “capital controls.” • Actions to strengthen institutional arrangements aimed at increasing the cost of destabilizing speculation. This includes adaptation of the policies of the IMF to enable it to stand behind countries in times of financial market turbulence and perform the function of a lender of last resort. • Holding of a substantial proportion of inflows in the form of international reserves. The large buildup in emerging central bank reserve assets during the 1990s reflects in part direct central bank intervention to prevent nominal exchange rate appreciation in the face of the substantial capital inflows. It also reflects concerns about the risks of a sudden reversal of capital flows.

The substantial accumulation of reserves by emerging market country central banks raises several issues about the efficiency of allocation of capital. Since reserve assets represent a component of national wealth, but are typically held in liquid risk-free, low-yield assets such as government securities in the mature markets—particularly U.S. Treasury securities—

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excess holdings of reserves would imply an inefficient allocation of national wealth. Thus it is ironic that from 1990 to 1996, some 49 percent of the $1.2 trillion of net capital flows in search of higher returns into emerging markets has ended up accumulated as reserves, a substantial proportion of which has then been reinvested back in low-yield instruments in the mature markets. This implies that the differential between the higher yield demanded and earned by investors from the mature markets in emerging markets and that earned on reserves reinvested back into the mature markets represents a cost that will ultimately be borne by residents of emerging markets. This cost could be substantial: given the yield spreads of emerging market debt, the cost could be of the order of $10 billion annually. For instance, Brazil increased its reserves over this period by $51 billion.9 Controls on Capital Flows

Given the challenges faced by countries operating in an environment of free capital markets, countries and international financial institutions that establish “the rules of the game” need to pragmatically evaluate different types of capital controls. In particular, the weaker market participants need a clear view of the optimal methods and sequencing for liberalizing their capital-account transactions and of whether certain types of controls are likely to help the participants attain their goals. In doing so, important distinctions should be made between controls on capital inflows and capital outflows, between general and selective controls, between market-based and quantitative controls, and between prudential controls and those imposed for balance-of-payment or macroeconomic reasons. Large capital inflows may lead to problems of overheating, of unwarranted appreciation of the real exchange rate, and of unsustainability of current-account deficits. In addition, large capital flows may complicate the conduct of monetary policy, with inflows causing monetary and credit expansion that may jeopardize the inflation target, and with large outflows leading to liquidity problems, high interest rates, and difficulties in the banking system. In spite of these problems, among mainstream academic economists10 and international financial institutions in general, the prevailing view is that capital controls are costly and ineffective. The overwhelming perception is that countries that impose capital controls are usually trying to counteract inappropriate domestic policies. Moreover, it is believed that government interventions in capital markets seldom accomplish the interventions’ stated objectives. However, recent attention to capital flows in the context of financial crises seems to be leading to a more pragmatic view of the role of capital controls, particularly of speculative capital flows. In a recent survey of the

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literature on controls over international capital transactions, Michael Dooley11 highlights the wide variety of market failures that may recommend the introduction of capital controls as the optimal policy response. As is well known from the theory of the second best, if the economy suffers from one distortion, it is possible to improve welfare through the judicious introduction of another distortion. Among numerous market failures, Dooley underscores sticky prices in goods and labor markets, distorting tax policies, anticipated trade reforms, and naive speculation. Another interesting and pragmatic view of the role of capital controls is provided by Bryon Higgins of the Federal Reserve Bank of Kansas, when discussing the role of capital controls in the context of the EMS. Higgins states that capital controls were an important element in the success of the EMS during the 1980s. Limiting international capital flows reduced the downward pressure on the exchange rates of the weak currency countries before they had made enough progress toward lowering their inflation rates. Moreover, controls enhanced the effectiveness of central banks’ interventions in currency markets, in part by insulating domestic credit markets from interest rate increases necessary to defend exchange rates. Capital controls were thus an instrument that enabled EMS countries to achieve the dual objectives of limiting exchange rate volatility and achieving a convergence in inflation rates toward that in the strong currency zone anchored by the Bundesbank.12

Additionally, a new line of argument in favor of capital controls is based on the possibility that distortions in the domestic capital markets of economies receiving private capital encourage inefficient investment and consumption decisions. This line of thought highlights the link between strong capital inflows and the overextension of credit by the banking system. Along more theoretical lines, the case for constraints on capital mobility can be made for economies in which there are multiple stable economic equilibriums. In practice, countries have attempted to discriminate between temporary and permanent flows in order to diminish the problems associated with short-term volatile flows. Ideally, countries strive to promote longterm direct investment and discourage short-term portfolio flows. In this context, if long-term flows represent a large part of total flows, the country is less vulnerable to a sudden reversal in market perception since long-term capital is more difficult to withdraw from a country. Moreover, long-term flows respond to medium-term fundamentals as opposed to short-term cyclical fluctuations in perceptions or interest rates. Dooley summarizes many of the second-best arguments for the introduction of capital controls. For example, regarding the long-run effects of capital controls, he quotes the work of Bernard Delbecque, who incorporates the current account in the monetary models, and Daniel Gros, who

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models speculative attacks but points out that although capital controls can limit private-sector speculation in most cases, governments are forced to augment the capital control program with domestic interest rates that are much higher or lower than would be the case in the absence of speculative pressure.13 An important aspect of this framework is that controls are effective but can be overcome at some cost to the speculator. The modern literature on the macroeconomic effects of capital controls focuses on long-run effects. Including expectations about the long run as determinants of current economic behavior, this literature provides a link between capital mobility and the observed short-run behavior of the economy, explaining how this behavior is affected by controls over capital flows. In the context of a sticky price framework, a way to understand a link between liberalization and real exchange rate appreciation is to appeal to a model in which nominal shocks generate overshooting of nominal exchange rates and, therefore, changes in real exchange rates. Oren Sussman uses a version of the Dornbusch overshooting model to help explain an apparently unsuccessful liberalization of the capital account in Israel in 1977.14 Liberalization of the capital account in this model takes the form of eliminating controls supporting a tax on domestic asset yields and domestic bank loans. Sussman presents evidence that the controls in place generated large differentials between onshore and offshore lending deposit rates in Israel, both before and after the brief experiment with liberalization. Sebastian Edwards and Jonathan Ostry present a model in which endogenous changes in relative prices of traded and nontraded goods interact with capital controls to affect welfare.15 Anticipated changes in relative prices alter the “interest rate” relevant for the intertemporal consumption and investment decisions. Capital controls also alter intertemporal consumption and investment decisions. Edwards and Sweder van Wijnbergen develop two ideas that are useful.16 First, they show in a static model that capital-account liberalization in the face of trade distortions can be welfare reducing. The intuition is that tariffs can distort investment decisions and capital controls can, in principle, offset this distortion. They develop a two-period model in which capital inflows are constrained. In this case, gradual liberalization of the trade account generates expected changes in relative prices that can distort investment decisions. Dooley and Kenneth Kletzer argue that simultaneous gross capital inflows and outflows are frequently the response of private investors to a variety of government guarantees and subsidies.17 If it is not possible for the government to credibly refuse to grant subsidies and guarantees, quantitative restrictions on some capital inflows and outflows can be welfare improving. Taxing short-term inflows is a method used by countries trying to discourage speculative capital movements. Some countries require a nonremunerated reserve deposit at the central bank for firms’ liabilities associated

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with direct borrowing in foreign currency. This reserve requirement should be maintained for the duration of the loan and should apply to all loans with a maturity of, say, 5 years or less. A tax rate for various maturities precisely tries to discourage foreign borrowing at short maturities. In the case of trade, relaxation of trade restrictions would, other things being equal, generate a depreciation of the real exchange rate, while relaxation of the capital account is assumed to call for an appreciation of the real exchange rate, given the capital controls’ effective limiting of desired inflows of capital. This “competition of instruments” problem may be resolved by delaying liberalization of the capital account until trade and other distortions have been eliminated. Capital inflows may also be deterred by establishing quantitative limits. In many cases, capital controls of this sort have been justified on prudential grounds. Examples of this type of controls are limitations to the foreign currency liabilities that commercial banks may have as a percentage of their total loan portfolio. Jeffrey Frankel and Andrew Rose present evidence that successful speculative attacks are less likely to occur in countries with a relatively high share of direct investment inflows.18 One interpretation of this evidence is that in countries where foreign investors bypass domestic financial markets, particularly banks, foreign savings are more likely to be transformed into productive capital. This conclusion tends to support the view that imperfections in domestic financial markets justify measures that discourage excessive portfolio-capital flows. Either with price-based controls or quantity-based controls, their effectiveness depends to a large extent on whether the inflows are of a temporary or permanent nature. The longer the inflows persist or the longer the policies remain in place, the greater the chances that the controls become less binding and create greater distortions in the financial system. In the case of capital outflows, controls may play a useful role in countries facing a balance-of-payment crisis. In extreme circumstances, controls may give a country time to deal with a run on its assets. One of the main functions of controls on capital outflows is to promote orderly conditions in financial markets and prevent the generation of vicious cycles in the exchange rate, stock market, and, in general, financial markets. Nevertheless, it is important to highlight the impact on the reputation of the country of introducing temporary controls on capital outflows. Therefore, countries should be cautious when considering the introduction of this sort of measure. In summary, there may well be a role for capital controls, at least in the short run, particularly in the case of large capital inflows that are of a speculative short-term nature. In designing the most appropriate type of controls, it must be kept in mind that effective controls are generally temporary and targeted. Controls should be designed to deal with the underlying causes of the inflows.

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The potential risks posed by the growing integration of financial markets should be addressed through enhanced institutional cooperation among governments, in spite of the implied difficulties; and this cooperation should not be influenced by market disturbances. In general, the new challenges posed by the growth and liberalization of financial markets call for a parallel development of international financial institutions to enable the institutions to act as overseers and, when appropriate, as regulators of international capital flows. The IMF should be at the center of international monetary cooperation. One of the purposes of the IMF set out in the first of the Articles of Agreement is “to give confidence to members by making the general resources of the Fund temporarily available to them under appropriate safeguards, thus providing them with opportunity to correct maladjustments in their balance of payments without resorting to measures destructive of national or international prosperity.” To fulfill its mandate, the IMF—that is, the international community—needs to be willing and able to provide sufficient liquidity to countries facing a financial crisis to stem the crisis’s destructive effects. For this purpose, in today’s global environment and with the increased scale of international capital flows, the size of IMF loans needs to be reexamined. The amount of readily available resources has to be increased very substantially. Additionally, the IMF has to be ready and willing to lend a substantial amount of resources to a country that may face a run on its assets for speculative reasons. In recent crises, the IMF was able to provide very large loans relative to a country’s quota by invoking the “exceptional circumstances” clause. However, this was done on an ad hoc basis and does not provide any guarantee that it will be available in the future. But if capital market liberalization increases the likelihood of crises, it is certainly appropriate to review IMF lending criteria, to ensure that IMF loans—in some cases together with other supporting funding—will remain adequate to their task. The increased scale of international capital flows is a recent phenomenon that calls for an increase in the financial support provided by the international community. To deal with it, the IMF should be ready to provide massive support to countries facing speculative attacks before they fall prey to a crisis, rather than come in, after the event, to pick up the pieces. International support can fend off a speculative attack on a country with sound policies, as shown by the experience of France in 1992. However, in recent instances of speculative attacks leading to a financial and exchange market crisis in emerging market economies, financial support has only been provided after the event. Thus, instead of preventing the crisis, international assistance arrives to back up a procyclical adjustment program. This in turn aggravates the recession and the difficulties faced by the financial system.

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In recent years, four countries have requested the support of the IMF following a sudden reversal in market confidence: Mexico (1994), and Thailand, Indonesia, and Korea (1997). The sudden reversals in market confidence have created a new kind of problem for emerging markets and for the IMF. Indeed, the IMF’s managing director characterized the Mexican crisis as “the first financial crisis of the 21st century,” recognizing that it was different from earlier financial crises and implicitly suggesting that it called for a different response from the IMF. How has the IMF responded? It has taken the view that “a financial crisis calls for a similar response as any other balance of payments problem except that the response should be quicker and possibly much larger than in a more traditional case.”19 Essentially, the IMF has sought to provide sufficient financing to promote a restoration of confidence in the framework of an adjustment program. As usual the authorities have had to ensure that they were taking the steps necessary to correct the problems that had caused the loss of confidence and adopting policies that would permit a return to a “sustainable growth path.” In all four cases, the IMF provided an exceptional amount of resources that were heavily front-loaded. The size of the arrangement and the degree of front-loading, following the traditional IMF approach, reflected judgments regarding the amount necessary—given forceful adjustment measures and the resources made available by other participants in the packages—to restore confidence. An important consideration in making the judgment was the amount of short-term exposure for which there was a significant risk of no rollover. Note that the above statement seems to imply the following:

1. Loss of confidence is due to poor policies on the part of the country. 2. The best approach to the financial crises arising from a loss of confidence is to let the crisis erupt and then to try to restore confidence with an economic program with large financial support. 3. Investors should be protected from market risks.

All three assumptions are questionable. The IMF approach is ill suited to deal with confidence crises that do not result largely from major disequilibriums in the fiscal aspects or monetary or exchange system. By emphasizing the contraction of demand and the rise in interest rates to strengthen the balance of payments the approach leads to a sharp recession that could often have been avoided, with the consequent social and political strains. In turn, the combination of recession and rising social and political tensions aggravates uncertainties, discourages investment and capital inflows, and leads the domestic financial system into trouble—which in turn aggravates the fiscal problems, or inflation and loss of confidence. Typically, this course of events deepens the crisis rather than overcoming it.

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The essence of the problem is that countries often face a confidence crisis, a problem of mass psychology that may bear little relation to the countries’ economic fundamentals. Financial markets may overreact and aggravate the bad news. The approach should be to prevent the confidence crisis, to sustain confidence before the crisis develops by a combination of timely and ample financial support, coupled (if appropriate) with a policy package. Typically, a crisis of confidence in the country’s capacity to make payments leads to a run on the currency provoking a panic devaluation of some 100 percent or more that goes well beyond the correction that may have been necessary to restore a sustainable balance on the external accounts. The sequel to this panic devaluation is well known, as domestic prices of tradables rise, inflation goes up sharply, and, consequently, domestic interest rates skyrocket. Wages typically lag behind, leading to a fall in consumer demand, and, because of uncertainty, a fall in investment occurs. The combination of lower demand and higher interest rates leads to a decline of GDP and rise in unemployment. By requiring fiscal equilibrium or retrenchment, the IMF program aggravates the recession as fiscal policy becomes procyclical. By then, in the circumstances of lack of access to noninflationary sources of finance, this becomes the best response available to the authorities, since deciding to relax fiscal policy could lead to a collapse of confidence in the viability of public finances and an even larger crisis.20 The impact of the combination of recession, higher unemployment, and high interest rates almost inevitably leads to a banking crisis. For instance, mortgage holders, who typically account for 20 to 25 percent of a bank portfolio, find that they are unable to meet payments that are much higher than those originally envisaged. A similar problem is faced by firms that see sales fall and debt-service payments rise. In this context, it is interesting to highlight the views of J. Stiglitz, a well-known academic economist and currently the World Bank chief economist, who is critical of the IMF’s failure to distinguish between Asia’s recent problems and the more fundamental failings of many Latin American and African economies in the past.21 The IMF’s demands for austerity, he suggests, will prolong Asia’s agony. Stiglitz also argues that Asia, with its high savings rate, strong work ethic, and high productivity, should not be lumped together with the classically mismanaged undeveloped economies, thus avoiding pushing the Asian countries into severe recession. For Fishlow, a senior fellow at the Council on Foreign Relations, none of the current IMF programs in Asia are currently valid because they all assumed that currency depreciation would be checked with the first infusion of external financial support. Moreover, the policy squabble between the IMF and its critics is distracting attention from what appears to be a systemic failure of global capitalism and is making pragmatic problemsolving more difficult. Fishlow argues that the old rules did not work and the new ones have not yet been invented.

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David Malpass considers that IMF programs almost invariably fail, for they violate numerous economic principles.22 First, they ignore the direct causal connection between devaluation and inflation. Second, the IMF programs ignore the exchange rate, even though creating a stable exchange rate is the single most important part of any economic program to restore confidence. Third, the IMF programs put heavy emphasis on fiscal balance, even though countries in recession should be expected to run deficits. Fourth, as part of their fiscal fixation, IMF programs specify tax rate increases, which sap the economic growth these countries need. Fifth, the IMF sets out to limit a country’s future growth rate in other ways. Countries are being punished for investing too much. Both Jeffrey Sachs and Malpass argue that the IMF persists in the belief that its programs are well designed and constructive, and that regardless of the damage caused by its prescription of currency weakness and tax increases, it will shift the blame for continued crisis, as it has in Indonesia.23 Lender of Last Resort

The increase in the volume and volatility of capital movements means for emerging markets a greater probability of balance-of-payment problems emanating from the capital account with the consequent spillover effects on the domestic economy, including the domestic financial markets. The evolution of the global economy and financial market integration, often leading to financial crisis, make a strong case for strengthening the ability of the IMF to respond rapidly to members facing financial emergencies. In a world of free capital mobility, and with open capital accounts of the balance of payments, emerging market countries having good economic fundamentals, pursuing sound macroeconomic policies, having a robust financial system, and providing clear and transparent information need an institutional mechanism to cope with sudden market disturbances, in particular to deal with contagion effects, with herding behavior and unexpected changes in market sentiment. The costs of inaction in the face of speculative disturbances are too large in terms of reduced output and employment to simply leave a country to ride the speculative wave on its own. The traditional approach by international organizations and industrial countries to a financial crisis in an emerging economy is to believe that the market is right. The first thought is that since the country is under attack it must have been at fault, and that there were some policy mistakes being corrected by market forces. This view fails to recognize that we live in a world of perceptions, where mass psychology forms expectations, and that markets have imperfect information and frequently overreact. At times of apparent vulnerability speculators seek to make a profit by selling a currency short, irrespective of economic fundamentals. In this regard, there is wide scope for enhanced

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international cooperation that may center fundamentally in the realm of confidence building. If markets believe that there is the determined will of the international community to back up countries facing unwarranted speculative attacks, markets will be more cautious in their investment behavior. To put it in economic terms, international cooperation, through a mechanism like the one described below, may substantially raise the cost for investors in herding behavior. The IMF, if endowed with adequate instruments and resources, could ensure that a country with solid fundamentals and facing a speculative attack on its currency could resist. Moreover, with sufficient resources and adequate surveillance, the IMF could stand behind a country that faces a run on its currency or, in general, on its assets. The IMF would act in a fashion similar to a central bank that stands at the core of the domestic banking system. On most occasions, the sole existence of a permanent standby or line of credit would suffice to allay the fears of the market. However, if a speculative attack did occur, the IMF would stand ready to provide ample liquidity to a solvent member country to deal with creditor panic and thus spare the country from a drastic contraction in output and employment. Financing by the IMF would be available in circumstances that threatened to create a crisis in a country whose policies the IMF had endorsed through the surveillance process. There may be some problems in identifying such an emergency and the appropriate timing, but the Executive Board could be rapidly briefed on the situation of the member country faced with an exceptional situation threatening its financial stability. The expectation would be that the financing would have an automatic character for countries that qualified for IMF support. Lending would be prudent since there would be a precondition that the IMF had recognized the country as solvent and approved its policies through the surveillance process. The temporary financing by the IMF would be safeguarded by measures adopted after the funds’ disbursement. The country would commit itself to undertake policy actions that would help ensure the restoration of confidence. The rate of charge would be sharply raised if the program was not complied with. Additionally, financing by the IMF would command a rate that could be a function of the length of time that the country has outstanding balances under this facility. Under these conditions the risk of moral hazard would be minimal. The sole existence of such schemes, leading to the awareness by markets that countries following sound policies have the liquidity support of the international official community, would in many cases suffice to maintain confidence. This would cut at its inception a run on a currency and give a country time to make adjustments, if required, in an orderly manner. The success of any attempt to overcome a balance-of-payment problem that threatens to set in motion a crisis is closely linked to the speed

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with which the country in question is able to obtain financial support and with the amount of that support. Therefore, an expeditious and automatic response for countries meeting the specified eligibility criteria is called for. At the same time, the amount of support committed needs to be very significant. There should be no doubt in the market about the sufficiency of the financial backing of the international community. A facility of this sort would provide an additional dimension of confidence to members and to the international monetary system. If fully credible, IMF resources would seldom be used. Moral Hazard

The desirability of an institution that acts as a lender of last resort is questioned by those who argue that it gives rise to moral hazard problems. The potential for moral hazard related to a lender of last resort may exist, but the risk should not be exaggerated. Moreover, this risk has to be weighed against the considerable benefits of avoiding a systemic crisis. In the case of the IMF, acting as lender of last resort raises two types of potential moral hazard problems. First, from the perspective of a particular country, critics argue that the lender of last resort could lead countries to loosen their economic policies since the countries know that markets will be more hesitant to attack their currencies, being aware that a country has the full support of the international community. However, there is no serious case to be made along these lines since IMF surveillance would ensure that only countries that follow correct macroeconomic policies would be eligible for emergency financing. To the contrary, the desire to become eligible for automatic IMF support in case of speculative attack would encourage the adoption of sound policies. Second, from the perspective of lenders to a country, the issue of moral hazard arises when the private sector is “too willing” to lend because it knows that a country in trouble will receive financial support in case of a crisis and, therefore, will not default. On this issue the international financial community must be very clear. The message to investors has to be that every time they make wrong decisions they will have to carry the losses involved. The risks arising from the volatility of capital, which today fall largely on the recipient country, must be shared by investors. The moral hazard, which must be eliminated, results from investors’ being rescued by the financial support packages. Under market rules investors take risks and may gain high returns—or suffer heavy losses. However, when risks have materialized investors have been saved from their mistakes by international rescue operations. For instance, in recent financial crises investors in

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equities suffered great losses, but investors in fixed-income securities did not: the external financial aid provided to countries helped investors recover the investment with no capital losses. This type of action constitutes a bad precedent because lack of punishment to investors for their mistakes makes them more imprudent in the future. Thus gains are private but losses are socialized and absorbed by the recipient country, which faces severe unemployment, a fall in real income, and a banking crisis resulting from a panic devaluation and a recession. Investors must be made aware of the impact of their actions on the economy of the country and provided with incentives to act responsibly from a social point of view. This may mean that if a sudden and massive reversal of capital flows—a run on the country—were to cause a major financial crisis in the country concerned, the authorities, in consultation and under the supervision of the IMF, could impose certain limitations (e.g., a schedule on capital withdrawals). This would be consistent with the purposes of the IMF, in particular with the provisions of Article 1 of its Articles of Agreement. Nevertheless, the necessary amount of resources to face a systemic crisis can be so high that better international surveillance, improved market performance, and reinforced policy coordination among the main economies certainly need to complement the lender of last resort. Conclusions

The advantages of free capital movements are widely acknowledged. For any country the benefits are an increase in the potential pool of investable funds and the access of domestic residents to foreign capital markets. For the world economy, open capital accounts support the multilateral trading system by broadening the channels through which developed and developing countries alike can finance trade and investment and attain higher diversification. In this regard, access to a pool of global savings means cheaper financing for governments and domestic corporations. These are benefits that every country may enjoy as a result of access to international capital markets. However, integrated financial markets have the ability to influence and modify national economic policies. In this context countries must meet several preconditions in order to minimize the risks of volatile capital movements. Sound economic policies must be in place to help avoid sudden capital flow reversals, and the policy framework should be geared toward minimizing vulnerability to sudden changes in market sentiment. Nevertheless, recent experiences show that even countries that have very solid fundamentals may be subject to speculative attacks leading to a crisis

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of confidence. In this environment, there is a need to develop ways and means of protecting countries from the occasional overreactions and excesses of the market. Two general lines of action are suggested to try to counteract the impact of market overreaction on financial markets in developing countries. On the one hand, there should be actions to limit the free flow of resources referred to as “capital controls,” which generally should be temporary and targeted, including increasing the cost of crisis to speculators by making them suffer losses or limiting on certain capital withdrawals. On the other hand, there should be actions to strengthen institutional arrangements aimed at increasing the cost of destabilizing speculation, which should take the form of a lender of last resort facility to countries. Such a facility could be operated by the IMF to respond rapidly to support members facing financial emergencies. Developments along these suggested lines would permit the world to benefit from the considerable contributions that international capital flows may make to the financing of economic development, while minimizing the risks posed by unbridled speculative capital movements to recipient countries. Notes

1. For a detailed description, see International Monetary Fund, “Evolution of the Mexico Peso Crisis,” International Capital Markets: Developments, Prospects and Key Policy Issues, World Economic and Financial Surveys, August 1995. 2. See International Monetary Fund, “Developments and Prospects in Emerging Markets,” International Capital Markets: Developments, Prospects and Key Policy Issues, World Economic and Financial Surveys, September 1996, Table 13. 3. See G. K. Helleiner, “Capital Account Regimes and the Developing Countries,” Studies on International and Monetary and Financial Issues for the Group of Twenty Four, Intergovernmental Group of Twenty Four on International Monetary Affairs, September 1996. 4. For an excellent treatment of this topic, see Luis Angel Rogo Duque, “Los Mercados Financieros Internacionales en el Mundo Actual,” Lección Magistral, Universidad de Alcalá, May 1995. 5. Bank for International Settlements, 53rd Annual Report, June 1983. 6. George Soros, “Avoiding a Breakdown,” Financial Times, 31 December 1997. 7. See Ariel Buira, “The Effective Cost of Capital,” in Less Developed Countries External Debt and the World Economy, El Colegio de México/CEESTM, 1978. 8. If the flows are stable, it would probably be wrong to sterilize some of them. In any case, the decision to sterilize depends on whether it is convenient or not to increase the level of international reserves, and the effects of capital inflows on aggregate demand. However, if the capital inflow is concentrated at the beginning of the process, and then tapers off to a lower flow, it is convenient to sterilize part of the inflow during the initial period before the inflow reaches its

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sustainable level. In practice it is difficult to assess accurately the timing and size of inflows. 9. The cost is estimated by multiplying the yield spread on emerging market debt by the reserve holdings of emerging markets. See International Monetary Fund, “Developments and Prospects,” 1997. 10. Among academic economists, Jagdish Bhagwati is an exception in his thinking on capital controls (see his interview in Times of India, 31 December 1997). For instance, when asked why the IMF takes the approach that it does, and in particular why it insists on capital-account opening in countries that are awash with domestic savings, he replied, “Wall Street has become a very powerful influence in terms of seeking markets everywhere. Morgan Stanley and all these gigantic firms want to be able to get into other markets and essentially see capital account convertibility as what will enable them to operate everywhere. Just like in the old days there was this military-industrial complex, nowadays there is a ‘Wall St.–Treasury complex’ because Secretaries of State, like Rubin, come from Wall Street. . . . So today, Wall Street views are very dominant in terms of the kind of world you want to see. They want the ability to take capital in and out freely. It also ties in to the IMF’s own desires, which is to act as a lender of last resort. They see themselves as the apex body which will manage this whole system. So the IMF finally gets a role for itself, which is underpinned by maintaining complete freedom on the capital account.” Bhagwati goes on to observe that many countries have grown well without capitalaccount convertibility, including China today and Japan and Western Europe earlier. “In my judgement it is a lot of ideological humbug to say that without free portfolio capital mobility, somehow the world cannot function and growth rates will collapse.” 11. See Michael P. Dooley, “A Survey of Literature on Controls over International Capital Transactions,” IMF Staff Papers, vol. 43, no. 4, December 1996. 12. Bryon Higgins, “Was the ERM Crisis Inevitable?” Economic Review, Federal Reserve Bank of Kansas City, fourth quarter, 1993. 13. Bernard Delbecque, “Dual Exchange Rated Under Pegged Interest Rate and Balance of Payments Crisis,” Journal of International Money and Finance, vol. 12, April 1993; and Daniel Gros, “Capital Controls and Foreign Exchange Market Crises in the EMS,” European Economic Review, vol. 36, 1992. 14. Oren Sussman, “Financial Liberalization: The Israeli Experience,” Oxford Economic Papers, vol. 44, 1992. 15. Sebastian Edwards and Johnathan Ostry, “Terms of Trade Disturbances, Real Exchange Rates, and Welfare: The Role of Capital Controls and Labor Market Distortions,” Oxford Economic Papers, vol. 44, 1992. 16. Sebastian Edwards and Sweder van Wijnbergen, “The Welfare Effects of Trade and Capital Market Liberalization,” International Economic Review, vol. 27, 1986. 17. Michael P. Dooley and Kenneth Kletzer, “Capital Flight, External Debt and Domestic Policies,” Economic Review, Federal Reserve Bank of San Francisco, no. 3, 1994. 18. Jeffrey A. Frankel and Andrew K. Rose, “Currency Crashes in Emerging Markets: An Empirical Treatment,” International Finance Discussion Papers, no. 534, Board of Governors of the Federal Reserve System, 1996. 19. James M. Boughton, “From Suez to Tequila: The Fund as Crises Manager,” International Monetary Fund Working Paper, WP/97/90, 1997. 20. The destabilizing procyclical nature of fiscal policy in Latin America is most pronounced in bad times when fiscal policy is most countercyclical in industrial economies. See M. Gavin and R. Haussman, “Fiscal Performance in Latin America: What Needs to Be Explained?” IDB-OECD seminar, November 1997.

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21. Peter Passell, Economic Science, “Critics: The IMF Is Misguided: Skeptics: Too Much Rot in Asia,” New York Times, 15 January 1998. 22. David Malpass, “The Road Back from Devaluation,” Wall Street Journal, 14 January 1998. 23. Jeffrey Sachs, “The Wrong Medicine for Asia,” New York Times, 3 November 1997.

Bibliography

Bank for International Settlements (BIS) (1983). 53rd Annual Report, June 1983. ——— (1995a). “Fundamentals and Financial Markets: Changing Perceptions of Risk,” 65th Annual Report, June 1995. ——— (1995b). “Turbulence in Bond Markets,” 65th Annual Report, June 1995. ——— (1995c). “Exchange Rates and Capital Flows in the Industrial World,” 65th Annual Report, June 1995. ——— (1996). “Capital Flows and Financial Systems in Emerging Markets,” 66th Annual Report, June 1996. ——— (1997). “Financial Trends in the Emerging Markets,” 67th Annual Report, June 1997. Bhagwati, Jagdish (1997). Interview in Times of India, 31 December 1997. Boughton, James M. (1997). “From Suez to Tequila: The Fund as Crises Manager,” IMF WP/97/90. Buira, Ariel (1978). “The Effective Cost of Capital,” in Less Developed Countries External Debt and the World Economy, El Colegio de México y CEESTM, 1978. ——— (1995). “Reflections on the International Monetary System,” Essays in International Finance, No. 195. Princeton University, 1995. ——— (1996). “The Potential of the SDR for Improving the International Monetary System,” in The Future of the SDR in Light of Changes in the International Financial System, IMF, 1996. Claessens, Stijn, Michael Dooley, and Andrew Warner (1995). “Portfolio Capital Flows: Hot or Cold?” The World Bank Economic Review, vol. 9, no. 1, 1995. Commonwealth Working Group Report on the Role of National and International Policies Promoting Private Capital Flows, HM Treasury, July 1997. Corbo, Vittorio, and Leonardo Hernández (1996). “Macroeconomic Adjustment to Capital Inflows: Lessons from Recent Latin American and East Asian Experience,” The World Bank Research Observer, vol. 11, no. 1, February 1996. Delbecque, Bernard (1993). “Dual Exchange Rates Under Pegged Interest Rate and Balance of Payments Crisis,” Journal of International Money and Finance, vol. 12, April 1993. Dooley, Michael P. (1996). “A Survey of Literature on Controls over International Capital Transactions,” IMF Staff Papers, vol. 43, no. 4, December 1996. ———, Eduardo Fernández-Arias, and Kenneth Kletzer (1996). “Is the Debt Crisis History? Recent Private Capital Inflows to Developing Countries,” The World Bank Economic Review, vol. 10, no. 1, January 1996. ———, and Kenneth Kletzer (1994). “Capital Flight, External Debt and Domestic Policies,” Economic Review, no. 3, Federal Reserve Bank of San Francisco, 1994. Edwards, Sebastian, and Jonathan Ostry (1992). “Terms of Trade Disturbances, Real Exchange Rates, and Welfare: The Role of Capital Controls and Labor Market Distortions,” Oxford Economic Papers, vol. 44, 1992.

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———, and Sweder van Wijnbergen (1986). “The Welfare Effects of Trade and Capital Market Liberalization,” International Economic Review, vol. 27, 1986. Fernández-Arias, Eduardo, and Peter Montiel (1996). “The Surge in Capital InFlows to Developing Countries: An Analytical Review,” The World Bank Economic Review, vol. 10, no. 1, January 1996. Frankel, Jeffrey A., and Andrew K. Rose (1996). “Currency Crashes in Emerging Markets: An Empirical Treatment,” International Finance Discussion Papers, no. 534, Board of Governors of the Federal Reserve System, 1996. Gavin, M., and R. Haussman (1997). “Fiscal Performance in Latin America: What Needs to Be Explained?” IDB-OECD Seminar, November 1997. Gros, Daniel (1992). “Capital Controls and Foreign Exchange Market Crises in the EMS,” European Economic Review, vol. 36, 1992. Group of Ten (1997). “Financial Stability in Emerging Market Economies,” Bank for International Settlements, April 1997. Helleiner, G. K. (1996). “Capital Account Regimes and the Developing Countries,” Studies on International and Monetary and Financial Issues for the Group of Twenty Four, Intergovernmental Group of Twenty-Four on International Monetary Affairs, September 1996. Higgins, Bryon (1993). “Was the ERM Crisis Inevitable?” Economic Review, Federal Reserve Bank of Kansas City, fourth quarter, 1993. Husain, Ishrat, and Ishac Diwan (1989). “Dealing with Debt Crisis,” a World Bank Symposium, 1989. International Monetary Fund (IMF) (1995a). “Turbulence in Emerging Capital Markets,” International Capital Markets: Developments, Prospects and Key Policy Issues, World Economic and Financial Surveys, August 1995. ——— (1995b). “Capital Flows to Developing Countries,” International Capital Markets: Developments, Prospects and Key Policy Issues, World Economic and Financial Surveys, August 1995. ——— (1995c). “Evolution of the Mexican Peso Crisis,” International Capital Markets: Developments, Prospects and Key Policy Issues, World Economic and Financial Surveys, August 1995. ——— (1995d). “Policy Responses to Previous Surges of Capital Inflows,” International Capital Markets: Developments, Prospects and Key Policy Issues, World Economic and Financial Surveys, August 1995. ——— (1995e). “Controls on Capital Flows: Experience with Quantitative Measures and Capital Flow Taxation,” International Capital Markets: Developments, Prospects and Key Policy Issues, World Economic and Financial Surveys, August 1995. ——— (1995f). “Role of Domestic Financial Institutions in Intermediating Foreign Capital Inflows,” International Capital Markets: Developments, Prospects and Key Policy Issues, World Economic and Financial Surveys, August 1995. ——— (1995g). “Financial Sector Constraints on Crisis Management,” International Capital Markets: Developments, Prospects and Key Policy Issues, World Economic and Financial Surveys, August 1995. ——— (1996a). “Survey on International Capital Markets,” International Capital Markets: Developments, Prospects and Key Policy Issues, World Economic and Financial Surveys, September 1996. ——— (1996b). “Major Capital Markets: Trends and Recent Developments,” International Capital Markets: Developments, Prospects and Key Policy Issues, World Economic and Financial Surveys, September 1996.

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——— (1996c). “Recent Developments in Developing Country Capital Markets,” International Capital Markets: Developments, Prospects and Key Policy Issues, World Economic and Financial Surveys, September 1996. ——— (1997). “Developments and Prospects in Emerging Markets,” International Capital Markets: Developments, Prospects and Key Policy Issues, World Economic and Financial Surveys, September 1997. Malpass, David (1998). “The Road Back from Devaluation,” Wall Street Journal, 14 January 1998. Passell, Peter (1998). “Critics: The IMF Is Misguided; Skeptics: Too Much Rot in Asia,” Economic Scene, New York Times, 15 January 1998. Rojo Duque, Luis Angel (1995). “Los Mercados Financieros Internacionales en el Mundo Actual,” Lección Magistral, Universidad de Alcalá, May 1995. Sachs, Jeffrey (1997). “The Wrong Medicine for Asia,” New York Times, 3 November 1997. Soros, George (1997). “Avoiding a Breakdown,” Financial Times, 31 December 1997. Sussman, Oren (1992). “Financial Liberalization: The Israeli Experience,” Oxford Economic Papers, vol. 44, 1992.

11 Dealing with the Volatility of Private Capital Flows1 Javier Guzmán Calafell

The experience of the current decade illustrates with clarity the challenges that less developed countries (LDCs) face as a result of the volatility of private capital flows. During the period 1990–1996, the surge in the flow of private capital to the developing countries represented one of the salient developments of the world economy. The figures are impressive. Notwithstanding the uncertainty that followed the Mexican crisis of 1994, net private capital flows to LDCs reached record levels in 1996, and were equivalent to nearly six times the figure observed in 1990. Nevertheless, the crises in Mexico and then in Asia have provided painful reminders of the speed with which changes in market sentiment can be reflected in the evolution of capital flows. In fact, following the impact of the events in Asia, the rising trend in private capital flows to developing countries has been reversed. The flows are estimated to have shown a decline of more than 30 percent in 1997 in contrast to the level observed the preceding year. It is worth noting that in spite of this decline, the amount of private capital channeled to the developing world in 1997 is still equivalent to around four times that recorded at the beginning of the 1990s. The large increase in private capital flows to the developing countries in recent years is a clear signal of the growing insertion of the developing countries into the international financial markets. This process has presented LDCs with unprecedented opportunities. Financial integration heightens the potential for growth by improving resource allocation and by enhancing access to global savings. In addition, integration allows a broader spectrum of choices for portfolio diversification and, therefore, for the protection against risk. Unfortunately, as shown by recent events, financial integration is also accompanied by enormous risks. Market behavior is not always rational and can be led by herd instincts. Even economies with sound fundamentals can be subject to abrupt changes in market expectations as a result of contagion or spillover effects. Also, capital flows are highly sensitive to 251

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external developments, such as changes in international interest rates. Furthermore, the very flow of capital, which in the early stages represents evidence of confidence in an economy, has frequently planted the seeds of a subsequent attack on an economy’s currency. It is obvious, therefore, that the design of policies to cope with the volatility of capital flows is essential for the developing countries. But there are a number of other factors that make this subject especially critical for LDCs. First, the size of LDC economies pales in comparison with that of international capital movements, and consequently the potential for disruption in these economies is huge. Suffice to say that the staff of the IMF estimates that if institutional investors were to reallocate just 1 percent of total assets under their management toward the emerging markets, this shift would imply a capital flow of $200 billion, that is, around 80 percent of net flows of private capital to the LDCs in 1996.2 Second, the destabilizing potential of capital flows is particularly large in developing countries, given the frequent presence of institutional weaknesses in their financial markets that accentuate the potential for investor herding. Third, the process of international financial integration in the developing countries is only in its early stages. The forces that have fostered integration can be interrupted temporarily, as developments in the aftermath of the crisis in Asia have shown. However, these forces will not disappear overnight: technological advance and financial innovation will continue their rapid pace. Also, given the widespread consensus on the merits of financial liberalization and deregulation, additional efforts in both industrial and developing economies should be expected. Moreover, there is evidence of unused margins for the arbitrage of risk-adjusted rates of return worldwide. In sum, the extent to which the crisis in Asia will affect the flow of capital to the developing world in the short and medium term is still uncertain, but a substantial growth of the flow over the longer term is to be expected. Developing nations must prepare and adapt themselves for their continued integration into the international financial system. We, the developing nations, have no choice, and it is essential that we realize that the central challenge is to ensure that the benefits derived from this increasing insertion into global financial markets outweigh the potential costs. The implementation of economic policies to handle adequately the difficulties posed by the volatility of capital flows is a central element in these endeavors. The problems that policymakers face range between two extremes: one relates to the dangers derived from large inflows of foreign capital; the other is the risk of abrupt and substantial capital outflows associated with sudden changes in market sentiment. The foregoing is an extremely complex issue for which there are no solutions with a universal application. The appropriate policy response to volatile capital movements will vary depending on the country’s economic

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objectives, exchange rate regime, institutional constraints, and the causes and the composition of capital flows, among others. Nevertheless, on the basis of the experience provided by previous episodes of capital inflows and outflows, it is possible to point at some of the elements that need to be taken into account when dealing with volatile capital movements. In making these considerations, I do not pretend to make an exhaustive analysis of the impact of different instruments of economic policy on capital movements. Rather, my objective is to stimulate an exchange of ideas on this important subject by concentrating on seven issues. First, in a world of increasing capital mobility there is a substantial premium on the implementation of sound and prudent macroeconomic policies. Indeed, prevention is much better than cure. In today’s world the payoff for good policies is rewarded more generously than before; similarly, punishment in the case of policy mistakes is far more severe. Therefore macroeconomic imbalances giving rise to market nervousness must be corrected rapidly, before they present a threat of turning into an economic crisis. Similarly, governments need to act swiftly and firmly when faced with shocks or a decline of confidence. This may sound tautological, but a look at the recent experience in Asia is a reminder of the disturbing frequency with which this recommendation goes unheeded. And the issue is even more complicated than that. Giving advice of this nature in very general terms is rather straightforward, but the situation may be different as we move into the details. Let me give a few examples:

1. Capital mobility is changing our understanding of some of the macroeconomic phenomena. For instance, it seems to be quite clear today that large current-account deficits, however caused, are dangerous because they are likely to give rise to market nervousness. It is far from clear that this was the dominant view a short time ago. In 1994 many—and I do not exaggerate if I say most—analysts considered that the large currentaccount deficit then observed in Mexico was not a source of great concern because it was not caused by the public-sector deficit. 2. A typical recommendation for a country under fixed or managed exchange rates, and facing large inflows of capital and the danger of overheating, is to tighten fiscal policy. A tighter fiscal policy is deemed an efficient policy response in these circumstances because the policy alleviates the pressures on domestic demand and, by exerting a downward impact on interest rates, discourages additional capital inflows. The merits of a prudent fiscal policy are unquestionable. Few would dare dispute the importance of maintaining a sound fiscal position in a situation of highly volatile capital movements. However, there is a potential perverse effect of fiscal tightening on capital inflows that is seldom recognized. Namely, by enhancing confidence fiscal consolidation can in fact invite further inflows of capital, thus worsening the problem that tightening was intended to

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tackle. It is thus fair to ask why fiscal tightening is deemed an effective means both to contain the impact of capital inflows and to face episodes of capital outflows. Similarly, since adjustments to fiscal policy cannot be done on short notice, implementation of tightening in response to shortterm fluctuations in capital movements increases the risk that, at the end, its stance turns out to be procyclical. 3. Sterilized intervention is one of the most frequently used instruments to alleviate the impact of capital inflows on domestic demand. These policies allow the central bank to intervene in the foreign exchange market and simultaneously offset the accompanying injection of liquidity, usually through open market operations. The merits and disadvantages of sterilization policies are well known, and I do not need to repeat them. But in trying to illustrate the problems that policymakers confront in dealing with capital flows, let me point out a concrete example. In a situation of fears of overvaluation of the exchange rate and large capital inflows, what is a prudent monetary policy? One that sterilizes the inflows but keeps interest rates high, stimulates an appreciation of the currency, and risks giving rise to large quasi-fiscal losses? Or one that allows interest rates to decline somehow in response to the inflows and takes pressures off the exchange rate, but makes the country face the risk of inflationary pressures and a deterioration of the current account? When seen in light of these examples, the recommendation to implement sound and prudent economic policies reveals a number of nuances, which suggest that there are occasions in which the issue is not as straightforward as it appears at first glance. Second, under a situation of volatile capital movements the advantages of more flexible exchange rate regimes are accentuated. There are no rules of a generalized application regarding an optimal exchange rate regime, and the crucial aspect is the consistency between exchange rate and fiscal and monetary policies rather than the regime per se. However, flexible regimes have a number of merits. To start with, exchange rate flexibility introduces uncertainty that can discourage some undesirable capital inflows. Furthermore, in the event of capital outflows, the exchange rate absorbs some of the pressures on international reserves to accommodate the outflows. It is also well known that exchange rate flexibility allows a greater degree of independence in the implementation of monetary policy. Last, and certainly not least, flexibility in the exchange rate invites an earlier policy response to emerging imbalances and discourages irresponsible attitudes on the part of both debtors and creditors. This recommendation is not free of nuances either. For instance, the orthodox policy prescription under a situation of heavy capital inflows is to allow the exchange rate to appreciate. This option is supposed to have the advantages of insulating the domestic money supply from the expansionary effects of capital inflows and, when economic fundamentals warrant a real

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exchange rate appreciation, of effecting this adjustment via the exchange rate and not via higher inflation. However, the real world presents a rather different picture. The evidence shows that countries are reluctant to allow a significant appreciation of their currencies in response to episodes of large capital inflows. This is usually related to concerns about the impact on competitiveness of abrupt and large movements of the real exchange rate. Moreover, since financial markets in many LDCs are not highly developed and foreign exchange markets are often thin, the potential for large short-term exchange rate movements as a result of only a few transactions is very large. Notwithstanding these shortcomings, the advantages of more flexible exchange rate regimes under the current economic environment have gained increasing recognition. It is not surprising then to see that developing countries have moved overwhelmingly toward more flexible exchange rate arrangements in recent years. According to the IMF, while in 1975 only 10 percent of developing countries had flexible exchange rate regimes of one sort or another, the figure rose to 25 percent in 1985, and by the mid-1990s most countries had adopted more flexible exchange rates.3 This trend may receive an additional boost from the crisis in Asia, since the countries that showed the highest degree of vulnerability to speculative attacks were those with little exchange rate flexibility. Third, in a world in which capital flows are highly sensitive to bad news domestically and abroad, it is very important to maintain adequate reserve coverage both as a means to instill confidence and to face temporary needs. The recent crises have revealed the weaknesses of the traditional indicators of the adequacy of international reserves. In particular, it has been increasingly clear that in a situation of high mobility of capital, indicators based on the import coverage of reserves are becoming obsolete. Today, reserve coverage needs to be measured in relation to a broad range of monetary aggregates and banking system and government short-term liabilities. In this regard it may be interesting to note the following. According to the IMF, although roughly half of the capital flows channeled to developing countries during the period 1990–1996 was directed to build up international reserves, the accumulation does not appear to be as impressive when measured against these aggregates.4 This suggests that developing countries’ authorities are not paying sufficient attention to this issue. Fourth, macroeconomic indicators may not provide sufficient warning signals about the potential for volatility in capital flows. This is especially important in a globalized world economy, where disturbances in one country are rapidly transmitted to others through contagion and spillover effects. Under these conditions, countries may suddenly be faced with the reality that their vulnerability to external shocks is far greater than what their macroeconomic position would suggest. This was clearly the case in Korea and Indonesia, where macroeconomic indicators provided a reasonably

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strong picture before the economic problems in Thailand erupted. However, as those two countries began to feel the impact of the Thai situation, a number of underlying structural and governance weaknesses surfaced that made the crisis inevitable. The lesson is clear: structural reform and improved governance can be as important as macroeconomic stability to protect an economy from the volatility of capital flows. Fifth, it may be argued that in evaluating the policy instruments available to deal with the volatility of capital flows, one must attach a larger weight to those measures aimed at discouraging large inflows of foreign capital, particularly short-term flows. As the recent cases of Mexico and some Asian countries show, the most outstanding episodes of capital outflows usually have their earliest origins in the problems resulting from a previous experience of large inflows of short-term capital from abroad. Against this background, the imposition of controls on these inflows, especially for prudential reasons and in the presence of fragile banking systems, has been favored by some as a precautionary move to prevent a crisis from occurring. According to recent studies by the IMF and the World Bank, there is evidence available supporting the view that controls can influence the composition of inflows and, at least in the short run, the inflows’ volume.5 However, in evaluating whether capital controls can be useful in alleviating the impact of volatile capital movements, a number of elements must be taken into consideration. In the first place, it may be difficult to differentiate between short-term and long-term capital flows: information is available only after a lag, and standard balance-of-payment classifications are in general not very informative in this regard. In addition, capital controls give rise to distortions and tend to be effective only temporarily because individuals and firms usually find ways to circumvent the controls. As for controls on outflows, they have the additional disadvantage of introducing an element of uncertainty for investors, which may at the end foster rather than limit runs on the country’s currency. More generally, it is widely agreed that recourse to capital controls must be considered within the overall economic policy context. Indeed, as in the case of Korea and others, the margins made available by introducing capital controls, if any, will evaporate unless this policy instrument is supported by strong policy efforts in other areas. Sixth, the financial sector is too frequently the Achilles’ heel of episodes of capital inflows and outflows in developing countries. Capital inflows usually result in a substantial increase in bank lending, soon reflected in the buildup of assets of poor quality and short positions in foreign currency, thus exposing the financial system to large potential losses. In this context, the macroeconomic challenges generated by the large inflow of capital are accentuated by the microeconomic problems emerging in the banking system. This is especially the case in those countries where

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credit institutions are not well regulated and supervised. Moreover, if the banking system weakens following a period of capital inflows, the use of some instruments of economic policy, such as interest rates, is constrained by concerns about the ability of banks to survive the shock if the inflows are reversed. This has led in a number of cases to an uncomfortable position in which both action and inaction in the face of capital outflows raise doubts about the solvency of the banking system. It is therefore widely agreed that financial systems need to be strengthened by improving supervision and prudential standards, by streamlining internal bank management, and by enhancing the potential for market discipline. Not surprisingly, this sixth issue has been the center of extensive debate and analysis, and by now there seems to be a good understanding of where efforts should be concentrated. Nevertheless, questions continue to be raised. For instance, some doubts have been raised recently on the applicability to LDCs of early-warning systems used in industrial countries to identify banks in trouble.6 To be effective as supervisory tools these systems, which rely on such indicators as capital adequacy, asset quality, and liquidity, must meet a number of requirements. The latter include, in particular, adequate accounting standards and reporting systems; an efficient legal framework; and liquid markets for bank shares, subordinated debt, and other bank liabilities and assets that allow supervisors to monitor the quality of reported capital through market valuation. It has been argued that although a number of developing countries are now making serious attempts to deal with reporting and accounting problems, deficiencies in their legal systems remain a major obstacle, and more fundamental characteristics of the environment in which their financial markets operate prevent assessing properly the market value of bank capital. Other analysts have noted that capital ratios in many developing countries are similar to those in industrial countries, despite facing a much higher degree of risk and a more volatile environment.7 These concerns are an indication of the need to assess continuously the extent to which efforts to strengthen the financial sectors of developing countries take into consideration the sectors’ particular features. Seventh, transparency in the dissemination of economic and financial data can play an important role in the efforts to alleviate the volatility of capital flows. There are at least three ways in which transparency can help in this connection: (1) reducing the risk of surprises and therefore of sharp changes in market sentiment; (2) sensitizing markets and policymakers to potential threats, thus promoting timely economic adjustment; and (3) allowing investors to make more rational investment decisions and, therefore, fostering economic efficiency and stability through more comprehensive public information on a country’s financial condition. The importance of the release of timely and accurate data in the pursuit of financial stability is unquestionable, but we must be careful, first,

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not to exaggerate the role that transparency can play in preventing large fluctuations in capital movements and, second, to admit that in certain circumstances transparency has the potential to affect confidence adversely. Let me illustrate these points with the recent experiences of Mexico and Korea. It has been widely argued that the lack of adequate information on international reserves and Tesobonos (treasury bonds issued by the Mexican government and denominated in U.S. dollars) played an important role in the 1994 crisis in Mexico. This view is so popular that it has come to be accepted as a nearly universal truth. However, as revealed in an article written in The Economist at the end of 1995 by the deputy secretary of the U.S. Treasury, Lawrence Summers,8 we have to take these arguments with a grain of salt. Let me quote a few lines of this article: “Contrary to much that has been said, figures on Mexican Tesobono debt were freely, immediately and publicly available throughout 1994. And while foreign exchange reserve figures were provided irregularly, contemporaneous market reports contained quite accurate estimates.” With this information in hand, questions come to mind on the extent to which a presumed lack of transparency in Mexico was a significant factor behind the crisis. The recent experience of Korea provides another interesting perspective on the issue of transparency. It has been noted that creditors’ concerns over the level of this country’s international reserves and its amount of external debt maturing in the short term—and the consequent reluctance to roll these liabilities over—may have been emphasized by the dissemination of reports containing more detailed data on these variables. One may wonder, therefore, whether the calls for transparency that we frequently make are equally valid in all circumstances, and whether in certain cases the costs of greater transparency may exceed its potential benefits. It is clear from the comments I made above that it is far easier to agree on the general principles to follow in trying to cope with capital-account volatility than on the specific measures that must be derived from these principles. It is also evident that in dealing with the difficulties derived from capital movements countries need to react decisively and seek an appropriate policy mix to achieve this objective. But the challenges do not stop here. This is an issue of such complexity that the attempts to face it cannot rest exclusively on the shoulders of national economic policies. Parallel efforts in a range of other areas are required. These efforts include responsible policies on the part of industrial countries, adequate mechanisms of IMF and regional surveillance, and a substantial strengthening of the capacity of the international community to react to international emergencies. The latter has at least two components. On the one hand, we need to equip the IMF with enough resources to support member countries in trouble. The experiences of Mexico and Asia have reminded us once again that surviving in a world of volatile capital

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movements requires the availability of substantial amounts of external financing in cases of trouble. With the globalization of capital markets, the amounts involved are getting bigger and bigger. It is yet to be seen whether the 11th quota review at the IMF and the resources of the general and the new arrangements to borrow will allow the IMF to meet this task satisfactorily. On the other hand, we need to evaluate again the convenience of designing orderly workout procedures for those countries embarked on bold adjustment efforts and facing serious difficulties in continuing to meet external debt payments. The existing framework based on ad hoc solutions has revealed important limitations: (1) the period of uncertainty following financial crises is extremely long, (2) there are no mechanisms in place to foster the participation of bondholders (the largest creditor group in many cases) in restructuring efforts, (3) debtors are forced to absorb an excessive share of the burden of adjustment while many creditors escape unscathed from balance-of-payment crises, and (4) the amount of public money that needs to be devoted to meet episodes of financial instability is larger than could otherwise be. And there are more examples. The careful consideration of legal and institutional arrangements that allow the overcoming of these limitations is clearly needed. Given the complex issues derived from the volatility of capital flows, should we not think about the possibility of delaying as much as possible or avoiding altogether the integration of developing countries’ financial markets into the world economy? I do not believe that we can, and I am convinced that we should not. Why can’t we? As a result of the combination of a number of demand and supply factors, among them the persistent progress in the efforts of stabilization and structural reform that we should strive for, over the medium and long term developing countries will continue to attract capital flows in substantial amounts. Against the backdrop of rapid technological advance and financial innovation, the more progress that is made in strengthening these countries’ economies, the more the foreign capital that will be attracted, and the more difficult it will be to stop it from flowing in. Suppressed options in one country will tend to be displaced by others outside the reach of controls. Why shouldn’t we? The experience shows that integration into the rest of the world is an inevitable step in the process of economic development, and the capital account is not an exception. Endeavoring to thwart this integration would represent a step backward in our efforts toward development. It is important to be aware, however, that the liberalization of capital movements is a risky venture that must be managed with extreme care. It is true that those countries delaying the opening of their capital accounts the most will usually be the last to enjoy the accompanying benefits. But it is also true that those that embark on this process prematurely may delay

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this beneficial impact even more. Indeed, the design of an appropriate multilateral framework aimed at achieving an orderly liberalization of capital movements can be of central importance in this process. Notes

1. This chapter is a slightly edited version of a paper presented at the Extraordinary Ministerial Meeting of the G-24; Caracas, February 1998. The views expressed are the sole responsibility of the author. 2. IMF, International Capital Markets—Developments, Prospects, and Key Policy Issues (Washington, D.C.: November 1997). 3. IMF, World Economic Outlook (Washington, D.C.: October 1997). 4. IMF, International Capital Markets (Washington, D.C.: November 1997). 5. See, for instance, IMF, International Capital Markets—Developments, Prospects, and Key Policy Issues (Washington, D.C.: August 1995); and World Bank, Private Capital Flows to Developing Countries—The Road to Financial Integration (New York: Oxford University Press, April 1997). 6. See Liliana Rojas-Suárez, Early Warning Indicators of Banking Crises: What Works for Emerging Markets—With Applications to Latin America, InterAmerican Development Bank (December 1997). 7. See, for instance, M. Goldstein and P. Turner, “Banking Crises in Emerging Economies: Origins and Policy Options,” Economic Paper 46, BIS, 1996. 8. Lawrence Summers, “Summers on Mexico, Ten Lessons to Learn,” The Economist (December 1995).

12 The Labor Challenges of Globalization and Economic Integration Victor E. Tokman1

Globalization is advancing rapidly, stimulated by financial and commercial opening and profound technological changes, particularly in communications and transportation. Almost in parallel, most countries have joined integration processes, which in some cases are limited to economic activity and trade but in others are moving toward institutional, social, and political integration. Among the former, the best known are the Latin American Integration Association (LAIA), North American Free Trade Agreement (NAFTA), Caribbean Community and Common Market (CARICOM), Asian Free Trade Area, European Free Trade Area (EFTA), East Asian Economic Council (EAEC), and Asia-Pacific Cooperation Forum (APEC). Among the latter are MERCOSUR, the Central American Common Market, the Andean Community, and the EU. Most of the countries have also signed bilateral free trade treaties that complement the existing integrationist scheme; all this is in the framework of the agreements reached at the last round of the General Agreement on Tariffs and Trade (GATT) negotiations that created the WTO. Although globalization and integration have had positive results, they pose new challenges in many areas, including labor. Countries now face at least five major challenges. First, labor and wage policies must be designed in a framework of more limited economic independence, in which the demand for labor and the level of prices are very much influenced by the capacity of the national economy to compete internationally. Second is the necessary adaptation of labor costs to the requirements of external competitiveness, which affects wage policy and other social protection schemes and the modalities of employment contracts. Third is the free movement of workers between countries and the need to avoid discrimination in matters of protection. Fourth is the increased internal mobility of labor, which requires worker retraining and a reduction in the cost of the adjustment in industries and firms. Finally, there is the need to ensure that 261

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free trade results in equitable social progress, both domestically and internationally, between the different social groups, avoiding the introduction of new protectionist formulas and “social dumping.” This chapter briefly analyzes the processes of globalization and integration in the labor area, and then examines in more detail the major challenges posed by integration in the world of work. Strategies for Integrating Latin American Countries into the International Economy

Latin America has been rapidly integrating into the world economy, fundamentally in four ways. The first is multilateral. All Latin American countries without exception have adhered to the results of the Uruguay round of GATT negotiations, and most of them have ratified their membership of the WTO. This implies a commitment to the objective of achieving freer trade, with fewer barriers and easier access to world markets. The second way, which has received less attention but which in my opinion is the most important, is unilateral opening as part of the set of structural reforms introduced in the 1980s. Most of the Latin American countries have made unilateral tariff cuts without precedent in the economic history of this century. The larger economies, with the exception of Chile, began their opening between 1985 and 1990, when maximum tariffs ranged from 65 to 220 percent (Chile in 1973) and the average tariff from 24 to 94 percent. Only a few years later, at the end of 1993, the maximum tariff varied between 11 (Chile) and 35 percent (Brazil), and the average was between 10 percent (Venezuela) and 18 percent (Peru). Tariff levels were also reduced from a minimum of 10 (Mexico) and a maximum of 57 (Chile and Peru) to an interval ranging from a uniform tariff in Chile to a maximum of seven levels in Brazil. The reduction in levels of effective protection is even greater if the exchange delay prevalent in many countries during the adjustment period is included. Table 12.1 shows that in five of the seven countries considered there was an exchange lag at the end of 1993, which worsened in the following years in most countries. The third path to integration is through the burgeoning number of bilateral free trade agreements. At the end of 1994, 30 free trade agreements were in operation between the countries of the region. These are extendible agreements that establish temporary tariff reductions, generally from 2 to 5 years; although they do not eliminate tariffs, reductions are significant for a large percentage of the trade between the two countries. Finally, the fourth way, and one of the most dynamic, is the multicountry integration agreements. Old integration schemes have been reactivated, like the Andean Group, the Central American Common Market,

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and CARICOM, and new schemes have appeared. The main new schemes are NAFTA, which integrates the United States with Canada and Mexico; and MERCOSUR, which groups Brazil, Argentina, Uruguay, and Paraguay under a trade liberalization program that eliminated duties and other restrictions on reciprocal trade on 31 December 1994 (except for some products on a list of exceptions with an extended period to 31 December 1995). The Southern Common Market also established a common low tariff with third countries but a reduced dispersion (0 and 20 percent, with 11 tariff levels and a list of exceptions). These were very similar to the tariffs established for trade with third countries by the Central American Common Market and the Andean Community (Table 12.2). Now a new multicountry integration scheme is in progress that involves the entire region. This is the Free Trade Area of the Americas, agreed at the Presidential Summit in Miami in December 1994 and scheduled to come into being before 2005. Several factors explain why the integrationist dynamic in Latin America has speeded up. At least three more specific considerations are acting along with globalization. First, there is greater homogeneity between Table 12.1 Latin America, Selected Countries: Trade Opening Process Country

Argentina Brazil Colombia Chile Chile Mexico Peru Venezuela

Start of Opening 1989 1988 1990 1973 1985 1985 1990 1989

Maximum Tariff Initial– 1993 65–30 105–35 100–20 220–10 35–11 100–20 108–25 135–20

Levels Initial– 1993 –3 29–7 14–4 57–1 1–1 10–3 56–2 41–4

Average Tariff Initial– 1993 39–15 51–14 44–12 94–10 35–11 24–12 66–18 35–10

Change in Real Exchange Ratea –49 44 –4 –10 32 –15 –28 15

Source: ECLA, 1995. Note: a. Changes in the exchange rate correspond to exports from the year before the start of opening to 1993.

Table 12.2 Common External Tariff MERCOSUR Central American CM Andean Community

Minimum 0 5 5a

Maximum 20 20 20

Levels 11 na 4

Source: ILO Note: a. Decision No. 370 establishes a list of products with zero tariff: electric power, health, education, mass media, fishing, and shipping. na = not available.

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countries: politically, practically all the countries in the region have democratic regimes, and economically there is increased uniformity in the management of economies. Most countries have achieved short-term macroeconomic equilibrium, which allows them to transfer their concerns to growth and expansion of markets. This is, in my opinion, the second reason why integration is attractive, because economic reactivation has been tenuous and there are concerns in the countries about how to make it more lasting. Expansion of markets through trade is an important way to achieve this objective. Last, the global tendency to form blocs, which in the case of the region has been politically sanctioned by the Initiative of the Americas, has legitimated a trend that was already occurring in other parts of the world, and on a more limited scale in the region itself. Labor Effects of Integration

The ongoing integration process is having a positive effect on the expansion of trade and increased flow of investments, and is expected to produce an equally positive effect on generation of jobs, reduction in pay differentials, and sustained improvements in productivity and international competitiveness. These effects in the labor field are not yet visible because the opening and integration process is developing in parallel with two other processes: stabilization and productive restructuring. At least in the short term, these processes are reducing the quality of employment in the public sector and, to lesser extent, in modern private enterprise, as well as modifying the structure of such employment. As a result, the labor market is being subjected to different forces with different signs (expansionary and contractive), which as a whole are causing a deterioration of employment and income.

Trends in Employment in the 1990s2

In 1997 unemployment in Latin America averaged 7.2 percent, exceeding the 5.7 percent recorded in 1990, but slightly lower than the average maximum in the past decade. This result is the average of national trends based on the degree of progress made in the reform process. Unemployment has increased in the countries that began their reforms in the 1990s (except for Colombia), even though some attained accelerated economic growth rates during the period (Argentina and Peru). On the other hand, unemployment has fallen in all the countries that began their reforms in the 1980s (Costa Rica, Chile, and Bolivia). These countries achieved high economic growth rates (except Bolivia) and increases in employment that exceeded the increase in the labor supply. In countries that applied their reforms more recently, except Colombia, the highest proportion (85 percent) of jobs generated in this decade are

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in the informal sector, which mixes low-quality jobs with bad working conditions. In contrast, the modern sectors have led the generation of jobs in countries where reform has been prolonged (with the exception of Bolivia) and in some that have joined the process more recently (Colombia). The modern sector performed poorly as a generator of jobs because the level of employment in the public sector was stagnant or contracting, and in most countries the expansion of employment in large- and mediumsized firms did not compensate for the decline. In most countries, the process prompted a reduction in the capacity of the modern sector to absorb new entrants into the labor market in highly productive jobs. Informal employment accounted for 57.4 percent of nonagricultural jobs in 1996, up from 51.6 percent in 1990. The expansion of the informal sector has several connotations. First, these jobs largely relate to activities with reduced productivity and low income that grow at lower rates in relation to the high-income workers and the average. In these conditions, increased informal employment alleviates poverty by increasing the rate of employment in poor households; but this trend in the structure of employment affects equity, since by widening the wage differential it increases inequality in income distribution. Second, by concentrating the expansion of employment in the activities of low productivity, average productivity falls and affects efforts to increase competitiveness. However, mutations are occurring in the informal sector. Microenterprises are expanding at a very fast rate and are paying higher wages, although conditions of work continue to be precarious. Along with this expansion of the informal sector of the labor market the service sector has also grown, continuing the shift from production of goods to services. This change in employment has taken place very rapidly in half of the countries. The share of industrial jobs in the total has fallen between 3.5 and 5.5 percent in favor of services in Argentina, Costa Rica, Mexico, and Venezuela in the past 6 years. In some other countries, this transfer has been slower for reasons involving the maturity of the process of productive transformation (Chile); and in others because of a more gradual opening process (Brazil, Colombia, and Peru); and last, because of the lower incidence of industrial employment in the total (Panama). As a result, for the countries under consideration the share of services in total employment had increased by 75 percent toward the middle of this decade. However, employment in the service sector as a percentage of the total remained constant in Chile and Colombia, but fell in Panama. On average, 90 out of every 100 new jobs generated in the 1990s has been in service activities. This share varies from country to country: in some, the generation of service jobs exceeds the total (Argentina), while in others it represents about 75 percent of new jobs (Chile, Colombia, Panama, and Peru). The expansion of the informal and service sectors in most of the countries of the region has been accompanied by policies aimed at increasing

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flexibility. Although these have prompted a more rapid adaptation of employment in firms, they have also generated increased job instability. This has happened in Argentina, Colombia, and Peru. According to household surveys, the number of workers hired in Argentina under all the different modalities of temporary contracts rose from approximately 2 percent of total contracts registered at the beginning of this decade to approximately 5 percent in 1996 and 6.5 percent in 1997. Eighty-five percent of the recent increase in employment in that country comes from temporary jobs. In Colombia, the share of temporary jobs in the total number of wage earners grew from 15.7 percent in 1990 to 18.0 percent in 1996. In Peru, over half the workers in the modern sector have temporary contracts. In short, the contractive effects of the policies of stabilization and productive restructuring applied in the region in this decade have generated insufficient jobs to absorb all the new entrants into the labor market, with a consequent increase in unemployment. Moreover, most of the new jobs are in service activities in the informal sector with low productivity and income. Modern wage-earning jobs have been deteriorating in terms of increased instability and lack of protection. Although this trend partly counteracts the positive labor effects of the trade opening and economic integration, it is important to examine the latter even though the fact that the processes are occurring simultaneously makes it difficult to distinguish the causes of recent market trends. The Effects of Integration on Employment, Wages, and Productivity

The reduction or elimination of tariff and paratariff barriers on imports should cause a relative cheapening of imported goods in each country. On the production side, this would result in a reallocation of factors to export sectors; and on the consumer side, a shift in spending toward imported goods, which are now cheaper than before the opening. The increase in exports should have a positive effect on employment, while the cheapening of imported goods should have a positive effect on real disposable income. That is, trade liberalization should raise levels of welfare. However, in the short term, the increase in employment resulting from an expansion of export activity may be offset by a reduction in employment in the sectors that produce goods that compete with imports. The need to compete in a now less protected domestic market forces those sectors to increase productivity that, at least at the start, is largely based on job cuts. The net effect on employment of the economic opening thus depends, first, on the trend in the demand for labor in tradable (exports and domestic goods in competition with imports) and nontradable (construction and services) sectors, as well as on the labor supply’s own momentum. This trend in labor supply and sectoral demand is certain to have consequences on the average wage in each sector.

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Another expected effect of the liberalization of foreign trade is the generation of an increase in the relative price of labor-intensive goods that use unskilled and intensive labor from developing countries. This results in an increase in relative demand for these workers and higher wages in comparison with the demand for skilled workers and their wages. Consequently liberalization could tend to reduce wage differentials. This argument is based on the fact that developing countries export to developed countries goods that are produced with relatively intensive unskilled labor (which is the developing countries’ most abundant factor), while they import goods that are relatively intensive in skilled labor (those countries’ scarcest factor). Trade liberalization would then increase the demand for unskilled labor in developing countries, decrease demand for skilled labor, both in relative terms, and reduce the wage differential between the two types of workers. In addition, since the sectors that move into exports must offer higherquality products, a price differential should occur between exportable products and the products for sale on the local market due to the effect of trade liberalization, which would be accompanied by higher relative wages in the export sector. As a result, three principal labor effects can be expected from a trade opening and economic integration. First, employment increases, especially in the export sectors, as does real disposable income. Second, real wages in the export sector rise and wage differentials between skilled and unskilled workers narrow. Finally, productivity increases, especially in the sectors producing tradable goods and services. To evaluate the size of these expected changes, the ILO Regional Office for the Americas conducted in 1995 comparative research in Brazil, Chile, and Peru.3 These three countries were selected to allow the inclusion of three different stages in the process: Chile, early liberalization (almost 2 decades ago); Brazil, intermediate (from the late 1980s); and Peru, recent (1990s). The results of this research led to the following conclusions. First, the size of the country affects the potential impact of the opening. In a very large country like Brazil (or the United States) domestic demand continues to be the engine of growth despite the opening process, while changes in relative prices inside industry as an effect of the opening only generate a restructuring in the intrasectoral occupational structure. While employment increases in some industrial sectors, in others it contracts. The net effect of this restructuring resulted, in the Brazilian case, in a net loss of industrial jobs in the 1987–1993 period. However, this loss was not uniform during the opening process, which suggests that in addition to the change in relative prices, other factors are behind the trend in sectoral employment. Second, the trend in industrial employment following the opening processes shows differences between large and small firms. In Chile, after the second stage of opening, firms in the sector increased their demand for workers, irrespective of their size. However, in Brazil and Peru, in a

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process that corresponded to the first stage of the Chilean opening, the large industrial firms cut their workforces, while small firms and microenterprises increased them. In Peru, the net effect of these differences between large and small firms was an increase in sectoral employment. In Brazil, however, the loss of jobs in large companies was so high that total employment in the sector fell. Third, there seems to be a first stage after the start of opening (the current one in Peru and the one in the 1970s in Chile) in which the relative demand for skilled workers increases, as well as relative wages. This strengthened demand is concentrated in the sectors that produce tradable goods that compete with imports, and in the nontradable sector in banking and insurance. However, the relative use of unskilled manpower increases in the export sectors. Both trends seem to respond to the predictions of the theory of trade opening on employment. In Chile, a negative relationship is observed between the changes in the employment structure and in wage differentials: the higher relative demand for a certain type of worker is accompanied by lower relative wages. However, this trend is not constant, since there are years in which the relationship is positive. In Peru, the increase in demand for skilled labor is accompanied by an increase in the relative wages of these workers and, thus, in a wider wage differential for less qualified workers. This positive relationship can result in a change in prices relative to nontradable goods, which expands their production by use of more modern technologies that make more intensive use of skilled labor. In a second stage of the opening process, in Chile from 1984, the trend during the first stage becomes clearer. The relative use of skilled labor increases in the sector in competition with imports and does not change in the export sector. Despite this, the negative relationship between the changes in the occupational structure and the relative wages recorded after the first stage of trade reform in Chile are not so clear in this second stage. There seems to be, therefore, a relatively clear trend: after the opening, the sector competing with imports increases its relative demand for skilled labor, while the export sector increases the relative use of less skilled workers. The relationship between the relative demand for workers by level of skill and relative wages has, in general, a negative character. These trends are due more to intrasectoral than intersectoral changes. On productivity, another recent ILO study in Argentina, Brazil, and Mexico4 shows the positive effect of the opening on aggregate productivity in the manufacturing sector. This increase in productivity is generally associated with a fall in the level of employment. It is not evident, however, that the opening in specific sectors provoked an increase in productivity in these sectors. It is possible that this lack of evidence is due to the level of aggregation of the sectoral accounts. In the larger economies of the region, the increase in productivity in the manufacturing sector was higher than the unit labor cost (except in

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Chile), which resulted in gains in competitiveness. During the 1990–1995 period, labor costs per hour worked in Argentina fell 2.0 percent annually, while productivity rose 7.0 percent annually. In Brazil, labor costs grew 2.9 and productivity 7.5 percent; in Mexico they grew 1.2 and 5.2 percent respectively, while in Peru labor costs gained 5.1 and productivity 6.6 percent. Still, this increase in productivity was offset by the exchange policies that followed, which resulted in a lagged exchange rate. This, in turn, generated losses in competitiveness in all the countries mentioned, except in Mexico due to the effect of the 1995 devaluation.5 In short, even with the limitations of the short period since the start of the trade opening, four conclusions can be reached in relation to the effects on employment, wages, and productivity. First, the relative size of the country conditions the effect of the opening on employment. Second, the effect on the level of employment is different in each country and seems to be related to the duration and form of opening adopted. In Chile, with a more mature opening, employment increased from 1984, and the large private corporations expanded their absorption of employment. In Brazil and Peru, the expansion of employment was concentrated in small firms and microenterprises. Larger firms reduced their workforce as a mechanism to increase productivity in the short term and meet greater international competition. Contrary to expectations, wage differentials by level of skill did not narrow, since the most highly skilled workers and managers benefited most from the measure. Last, the opening provoked a significant increase in the productivity of work in sectors producing tradable goods and services (manufacturing), which being higher than the rise in labor costs generated gains in competitiveness. However, in many cases, they were totally or partially annulled by the exchange policy that followed. The preceding analysis indicates the need to generate quality employment and improve productivity and competitiveness: in short, to ensure that the benefits of trade and integration result in social progress. The design and application of policies in this field has to be done in a different context due to globalization and opening. This means accepting the challenge of adapting to a framework with less independence, improved competitiveness, greater mobility in the domestic labor market and between countries, and a system of trade regulation that transforms the gains from liberalization into social progress. This agenda presents, then, at least five challenges, which are analyzed in the rest of the chapter. First Challenge: Wage and Employment Policies in More Interrelated Economies

Integration into the world economy affects the capacity of each country to introduce independent economic policies. External conditions become key

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factors in the policies’ design and application. This is very clear in relation to employment and wage policies. In the past, protected and closed economies were independent, and employment depended principally on the trend in effective demand, which could be managed by fiscal and monetary policies. In a Keynesian context, employment could increase if demand was expanding following an expansion in public spending. The counterpart was higher inflation rates, which were processed domestically through redistribution between profits and wages. In the present situation, price increases affect competitiveness and the possibilities of growth, and consequently the possibilities of more direct job creation. A similar situation occurs with the setting of wages, where the transfer from wage increases to prices could be processed through changes in demand and distribution. At present, the increased opening restricts the likelihood of making this transfer without affecting competitiveness. The first challenge, then, is to redesign employment and wage policies to adapt them to the new structure. Employment policies must recognize the limitations of expanding employment through spurious increases in demand and emphasize the increased capacity to compete, which means expanding productivity and cutting production costs. Expansion of productivity requires investment in the development of human resources, restructuring of production, and design of long-term productivity strategies that go beyond a short-term strategy based on cost reduction (principally by reducing the workforce). In the next section, I will return to reduction of costs, particularly labor costs. Wage policies have to be designed to bring wage adjustments closer to changes in productivity. In many cases, this means decentralizing forms of collective bargaining to allow greater flexibility in the wage structure, but without affecting the negotiating power of the trade unions. It is also necessary to introduce aspects linked to increases in productivity into collective bargaining (such as training) and to tie pay to results (through profit sharing). These innovations, which to some extent are already being partially introduced in some countries, would generate incentives to increase productivity while disciplining wage increases so as to absorb them without price increases. Apart from the design of labor, employment, and wage policies, the new situation creates the challenge of innovation in long-term policies, since the type of specialization that permits integration into international markets has to be defined; this is an important determining factor in the generation of employment. An export strategy based on natural resources and their processing, successful in the first stages, has to be developed toward products with more value added or the permanent renewal of products and markets, to reduce the fluctuations associated with international markets. However, emphasis on productivity increases in the most organized sectors, and the closer association with them of wages, leads to more

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inequality (as is happening). Policies are required that transfer the benefits to the rest of the population and, above all, bring informal and small-scale activities into the modernization effort, and use social policy to compensate the most vulnerable groups left out of the process. To ensure that the benefits of economic progress are adequately transferred to the field of employment and income requires efforts of supraregional coordination to facilitate the transfer. To achieve this at least three areas of coordination can be considered. First, new mechanisms of coordination have to be introduced to reduce instability and uncertainty. As mentioned earlier, greater integration means a loss of independence in national policies, as shown by the Mexican experience in 1995 and possibly the current one in Asia. There is a need to coordinate macroeconomic policies to prevent serious distortions and to have instruments available to keep fluctuations within manageable limits. There is also a need to reform public and private institutions to enable them to manage more complex and interrelated economies. For integration to generate economic expansion, which is an indispensable requirement for generating employment, it must operate in a climate of security and stability that attracts investments. Second, special attention must be paid to the transnationalization of firms. Privatization has opened up new opportunities for investment for local and particularly for foreign capital. New inter–Latin American investments have also taken place, sometimes associated with corporations from the developed countries. This renewed investment scene is complemented by innovations in financial markets, which range from the introduction of instruments to attract external funds to promoting domestic savings, whether through privatization of pension systems or the development of local capital markets. This process creates more internationalized and regionally integrated firms that require new instruments for operation: bilateral investment guarantee agreements, stable tariff and preference agreements, and coordination of fiscal, financial, and labor policies. Out of this comes a more internationalized private sector and management, which transcend national frontiers and are a primordial agent of the integration process. Likewise, trade unions also need to increase their international action. Their members’ interests are now affected by situations outside the national sphere. Finally, integration does not only mean greater interrelation between markets, people, and public and private sectors; there is also more interaction between the social and the economic areas. Investment, being increasingly the responsibility of local and international companies, requires incentives and stability, but stability is linked to the social legitimacy of the policies. These depend on the workers’ perception that they are receiving fair treatment, which is achieved by means of acceptable wages, adequate conditions of work, and balanced conditions for collective bargaining.

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The turbulence in the region in 1995 and the current Asian troubles have been almost exclusively attributed to economic imbalances; however, these upheavals also reflect the social imbalances caused by the new policies. There is, then, a need to link both aspects at national and international levels. Compensation for the most affected groups and promotion of new sources of employment are areas that can be tackled by countries acting jointly to create funds and mechanisms to facilitate the transition and favor the poorer countries and groups, although these areas continue to be a national responsibility. Second Challenge: Labor Costs, Productivity, and Competitiveness

The second challenge consists of reducing national costs and increasing productivity as mechanisms to improve international competitiveness. The reduction in national costs usually concentrates on cutting labor costs and attempting to generate jobs. At present, this is done in two ways: by cutting labor costs, mainly nonwage costs, and by increasing flexibility. This proposal assumes that labor costs restrict development of exports and hence generation of employment at the national level. In relation to wage and nonwage costs, I would mention four facts. First, industrial and minimum wages in Latin America are low, lower than 17 years ago. Second, the absolute levels of hourly wages in manufacturing industry in 1995 were less than $2 in Mexico and Peru, $3 in Chile and Brazil, and $4 in Argentina. In Korea, a country generally associated with exports based on cheap labor, hourly wages were $5. In the United States hourly wages are $12, and in Germany $15. Obviously wages are only part of labor costs; other costs have to be added in, and these are not low in this region. If we add in the total cost per hour in industry in Mexico and Peru, costs rise from $2.00 to $3.00; in Chile and Brazil to $4.20 and $4.70; in Argentina to $6.00. In Korea they rise to almost $6.00; in the United States $17.00; and in Germany $27.50 an hour. A third important fact is the percentage surcharge on the nominal wage, which ranges from 44 percent (Chile) through about 50 percent (Mexico and Argentina) to close to 60 percent (Peru and Brazil). These payroll surcharges are higher than in Korea, where they are around 22 percent, similar to those in the United States. In Chile, they are about 40 percent, but lower than in Europe, particularly Germany, where they reach 80 percent. Last, losses in competitiveness occur when costs are based fundamentally on product units. Labor costs per hour are low, but less so when the result in terms of production is included. Hourly labor costs, which are 17 percent in the United States, become 60 percent in relation to the cost per unit produced. In Korea they rise from 50 to 68 percent (Table 12.3).

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Table 12.3 Wages, Labor Costs, and Productivity in Manufacturing Industry, 1995 Country

Argentina Brazil Chile Mexico Peru

United States Germany Korea

Wage Cost per Hour (in current dollars) 4.01 2.94 2.91 1.88 1.81

12.33 15.40 4.59

Source: D. Martínez and V. Tokman, 1997.

Nonwage Labor Costs (percentage of wages)

Labor Cost per Production Unit

42.4 78.3 22.5

100 146 67

48.6 58.2 44.5 49.0 62.9

66 83 71 47 53

In this context of low wages, proposals to reduce costs have focused on reducing nonlabor costs, particularly payroll taxes to finance housing (Peru), training (Mexico and Brazil), and social security contributions. The reduction in costs is also complemented by more flexible employment contracts. Labor flexibility in Latin America has taken the form of modifying individual work contracts and occasionally decentralizing collective bargaining. Changes in individual work contracts in the region have gone in two main directions. The first is to open other options to the permanent work contract by introducing new job promotion and training contracts, along with temporary contracts. The second is to facilitate dismissal and reduce its cost by eliminating the obligation to reinstate in case of unjustified dismissal. This affects compensation—and facilitates dismissal for economic reasons and collective dismissals. The first method has meant that creation of new jobs is concentrated in these forms of atypical contractual forms. In Peru changes in the type of contract were introduced in 1992; in 1985 this type of contract accounted for 35 percent of jobs and now represents 50 percent. In Argentina the use of promotion contracts quadrupled in 1995 and 1996, and 85 percent of new jobs are now on these conditions. This rapid growth destabilizes the employment relationship, which results in lack of protection, fewer incentives for investment in training, and a reduced commitment to increasing productivity. In fact, there is a new trend to reduce the multiplicity of contracts. Recent proposals in Argentina are designed to reduce the number of contracts and concentrate on decreasing the costs of dismissal, and the same is happening in Spain. In both countries bipartite or tripartite agreements have been made to reduce the number of contracts, restrict their scope, and lower the cost of dismissal. The lesson is being learned that more flexibility is needed but not at the cost of instability. Last, the data presented above suggest that the problem of competitiveness is not so much high wages as low productivity. Studies confirm

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that average productivity in Latin America is, for example, one-third of the U.S. figure. Studies of the industrial sector as a whole and of individual industries—steel, food, and banks—confirm this result. Telecommunications is one of the few sectors where productivity levels come close to international levels, because it has experienced the highest degree of internationalization.6 Lowest productivity is recorded in automobile production: in Brazil and Mexico it takes 40 to 48 hours to make one automobile; in Japan, 17 hours of work; and in the United States, 25. Low productivity and poor growth are combined with characteristics of macroeconomic adjustment that are important determinants of competitiveness, and are as important in determining the development of competitiveness as changes in labor costs. Labor costs in terms of their purchasing power, that is, in terms of what the worker can buy, grow less than productivity in all countries, except Chile. But if the costs that interest the producer are taken into account, in terms of the price obtained for the products, labor costs grow more than productivity (Table 12.4). The same occurs if labor costs are expressed in dollars. These effects are also related to the type of macroeconomic adjustment. Almost without exception Latin American countries record exchange lags, which means that prices expressed in dollars continue growing. In addition, during periods of opening distortions in domestic prices occur. Growth in producer prices slows more quickly than consumer prices, producing a conflict of views between workers, who legitimately defend their capacity for consumption, and employers, who legitimately defend their capacity of production. The preceding analysis should not lead to the conclusion that labor costs are not important, but that the subject is more complex than simply blaming high wages or payroll charges for rigidity in work contracts and difficulties in exporting. There are possibilities for reducing labor costs, as several countries have shown, through changes in the social security system, Table 12.4 Labor Cost and Productivity in Manufacturing Industry, 1990–1995 (annual growth rate) Country

Argentina Brazil Chile Mexico Peru

Labor Costa (purchasing power) –2.0 2.9 4.3 1.2 5.1

Labor Costb (productive cost) 8.7 12.5 6.9 4.3 17.2

Labor Cost (in current dollars) 13.9 8.5 9.4 1.5 11.6

Labor Costc (without exchange lag) Productivity 9.6 1.3 7.7 5.4 8.4

7.0 7.5 3.2 5.2 6.6

Source: D. Martínez and V. Tokman, 1997. Notes: a. Deflated by the consumer price index; b. Deflated by the producer price index; c. At real exchange rate.

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and reducing the costs that affect unskilled labor, which is where the greatest potential effect of generation of employment lies. But priority must also be given to increasing productivity and correcting the undesirable consequences of the dominant type of macroeconomic adjustment. Third Challenge: International Mobility Without Discrimination

A more globalized and integrated world is increasing the movement of people between countries. Communications and information flow spontaneously, which generates movements of people, many of them in search of new opportunities of employment. This generates a series of demands in addition to the traditional ones. The size of these flows creates new problems that require solutions. For this analysis, it is useful to distinguish between illegal and legal migration. The former has been increasing not only from South to North, but also between countries of the South, not necessarily always between bordering states, and its increase is generating a double problem. First, illegal migrants form an important contingent of excluded people. They take unstable jobs without protection, and they have no guaranteed access to the minimum of social services provided by the state to all citizens in Latin American countries. In some countries this situation is aggravated by the personal and family insecurity of illegal migrants as a result of police action. There is therefore a need to move ahead with regularizing the migratory situation, with the social and labor integration of migrants as a first step. Second, illegal migrants enter the labor market without getting the benefits provided by the country’s labor laws and generally accepting lower than normal pay. This causes “unfair” competition with local workers, particularly the most organized, and erodes the protective capacity of labor legislation. Competition in the labor market, within the limits permitted by each country’s legislation, can increase efficiency, but in the case of migrants this competition is based on noncompliance with the law and lack of respect for fundamental labor rights, which are in fact violations of human rights. This requires more government inspection—and more sense of social responsibility by employers. In relation to legal migrants in similar situations of exclusion as illegal migrants, three comments apply. The first general point relates to the change in the structure of migrants, and particularly to their effect on labor relations. The second more specific point relates to acceptance of qualifications obtained in third countries. The third point is the need to guarantee the continuity of social security protection for migrant workers. Growing economic interdependence, integration agreements, and investment guarantees in the context of privatization have caused an increase

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in the transnationalization of companies. Unlike in the past, this is not limited to foreign capital from developed countries but increasingly involves intra–Latin American investments, sometimes associated with capital from developed countries. This situation results in a more organic migratory flow, associated with the productive development of certain sectors and generally involving higher levels of skills and responsibility than in the case of individual migrants. More important, the internationalization of companies and executives is added to the inertia of the transfer of the system of labor relations from the country of origin, which requires a degree of adaptation by the company and the workers to new forms of relationship. The panorama becomes more complex when it involves firms that operate in countries that are trading partners. In these cases, collective bargaining tends to incorporate elements that go beyond the local company or even the conditions of the country where it is located. There are already cases of negotiations through multinational trade unions and corporations in some sectors that reveal the differences in the systems of collective bargaining between countries and the need for coordination. At a more aggregate level, union coordination results in transnational action to ensure compliance with fundamental rights of workers and guides the negotiations in some specific sectors, as is happening in MERCOSUR. Thus, there is a need for the actors and their organizations to adapt to the rules of negotiation in a more internationalized framework of labor relations. The second point relates to the need to coordinate systems of education and vocational training to ensure that qualifications obtained by the migrant in his country of origin are recognized by the authorities in the host country, and that equality of opportunity with nationals holding the same level of qualifications is granted. If necessary, this coordination between systems can be achieved in the framework of integration by creating a supranational level responsible for validating qualifications. The third point relates to the specific need to coordinate national systems of social protection to guarantee the preservation of vested rights and transfer of contributions. Otherwise, migrant workers are doubly penalized because they lose their contributions and seniority in their country of origin and, by not accumulating them in the host country, their retirement pensions are reduced. The protection of migrants requires international coordination because of the growing diversity of national systems (after recent reforms), and because of the traditional concept of occupation in the territory of a country and in a job for life. In a framework of greater domestic and international labor mobility, rather than encouraging the mobility, the system penalizes it. The integration agreements that establish freedom of movement for workers require harmonization of social security policies based on four basic principles: (1) equality of treatment for nationals and nonnationals in social security matters; (2) formal determination of the social security legislation

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that is applicable; (3) preservation of vested rights, or rights in the process of acquisition; and (4) the possibility of receiving severance pay in a foreign country. Of these four basic principles, the first and third (equality treatment and preservation of rights) are the core of the problem, since the other two (applicable legislation and payment procedures) depend on how the first two are resolved. The core aspect relates to the preservation by the migrant worker of vested rights to a retirement pension acquired in the country of origin without losing the seniority accumulated in that country’s system. This means either that the social security contributions made in the host country are used to maintain seniority in the country of origin or that the contributions in the country of origin are recognized by the host country. The problem is very complex, and its solution requires some degree of financial integration of the social security institutions of the countries involved; the complexity is even greater in the case of the private pension fund management companies introduced in recent reforms. A policy of nondiscrimination makes it necessary to recognize that migrant workers have equal rights with local workers. The amount of pensions creates the difficulty that the value of the contributions made in the country of origin may be lower than that required in the host country. This is not a problem with private pension funds (individual capitalization systems), but the problem of seniority does exist in this case. With respect to the determination of the applicable legislation, workers must know which law is applicable, including workers permanently employed in a foreign country, workers temporarily located in another country, or workers who travel in different countries engaged on transport and other activities, including seamen. These provisions would clarify and guarantee the application of single legislation, which will prevent conflicts or conflicts between the different national laws. In general, the principle is that the applicable legislation is that of the country on whose territory the activities are carried out. This subject is particularly important in the cases of NAFTA and MERCOSUR. In NAFTA, the agreements specifically exclude the granting of any migratory rights additional to those established in the immigration laws of the respective member states. In contrast, in MERCOSUR the trend is to free movement of workers between countries. Diagnoses have been made to determine the existing situation and the legislation applicable to workers from one country employed in another treaty country. A high percentage of migrant workers are illegal residents outside the protection of labor law, without the protection of social security and membership of union and labor organizations. In the area of social security, there are no agreements that allow the host country to take into consideration the contributions or rights that migrant workers have in their countries of origin.

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To deal with this situation, Subgroup 10 of MERCOSUR approved in 1996 the Multilateral Agreement on Social Security. This agreement, which has been presented for final approval to the Group of the Common Market, establishes the general rule that “the legislation applicable [in the area of social security] is that of the place where worker carries out his activities” (Article 4). This means that workers and their families who temporarily move to another state receive the corresponding health benefits, if the managing entity of the country of origin so authorizes, and that contributions made in any of the contracting states and the period of contributions are considered in the granting of benefits for retirement, incapacity, or death in the form determined by an administrative agreement to be established to that effect. The administrative agreement mentioned in the Multilateral Agreement on Social Security establishes (Article 6) that for the granting of contributive benefits for retirement, advanced age, incapacity, or death, each contracting state will recognize the periods of contributions, as long as they do not overlap. Voluntary insurance is also included, when not simultaneous with a completed period of compulsory insurance in another state. It is also established that periods of insurance completed before the agreement are only recognized when the worker has periods of work to complete after that date. Fourth Challenge: Employability in a Context of Increased Occupational Instability

The new conditions of opening and globalization affect the movement of workers within each country. The movement of rural migrants to the cities has been losing momentum in Latin America as the urbanization process advances. The majority of these migrants, contrary to expectations, did not find jobs in the modern sectors, but had to be content with informal jobs that at least allowed them to earn enough to survive. Eighty-five out of every 100 new jobs generated in the region in the past 15 years have been informal. At the same time, the structure of urban employment has shifted to the service sector, which now provides nine out of 10 new jobs. Last, following the privatization process, in this decade the public sector has ceased to make a direct contribution to net job creation, in contrast with the four preceding decades when it contributed 15 out of every 100 new jobs.7 Keener international competition is accompanied by the need to restructure production to maintain levels of competitiveness. This means expansion or contraction of sectors and firms, as well as transfer of workers between them. The search for greater productive efficiency in a framework of increasingly unstable demand requires flexibility of production and,

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especially, work processes. Higher productivity is achieved at first by cuts in the workforce and in the longer term by reorganization of the work process inside companies. For workers the new conditions are a dramatic and costly change. From the career centered on a job or an employer they have moved to a situation where change of occupation, employer, and qualification requirements is increasingly the order of the day. The cost associated with this process is high and results in unemployment, long-term in many countries, and loss of protection and productive capacity. This process is an inevitable condition for dynamic integration into the new international economy. The challenge is how to ensure that workers are not affected and are given the opportunity to adapt to new conditions. The solution has to be found in developing employability, which means generating the capacity to enable workers to respond to new demands of the labor market without losing levels of social protection during the transition. The challenge consists of developing labor policies that combine active intervention with new forms of protection. The former must be directed at adapting qualifications to the new jobs, which are requiring less specialization and more creativity, initiative, and versatility. In practice, this is leading to the development of basic competence (rather than skills), which equips workers with a knowledge base that can be adapted according to need. This poses the challenge of linking education with the labor market, particularly improving the quality of primary education, which is where basic capacities are developed. The first component is to invest in retraining with a new approach and, possibly, in a different institutional framework. A second element is to facilitate access to information on job offers or to assist displaced workers to generate their own jobs. There is no doubt that the possibilities and costs of intervention decrease if the process can be anticipated and negotiated ex-ante, before the companies and sectors begin the productive transformation process. Labor retraining has to be accompanied by maintenance of protection. The existing systems of employment protection have to adapt to the new situation of protecting workers when they change jobs. Otherwise, affected workers are penalized by loss of protection and lack incentives to join in the productive transformation on a voluntary basis. New systems now operating in some countries (Brazil, Colombia, and Peru, and proposed in Argentina and Chile) replace dismissal compensation by the constitution of individualized funds that workers can withdraw in case of dismissal or resignation. These maintain protection during the transition period without loss of vested rights. As an alternative or supplement, it is necessary to introduce unemployment insurance and to guarantee permanent access to a basic protection network in the areas of health, education, and food, irrespective of the workers’ job status.

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In brief, the fourth challenge is to promote employability by combining retraining and the generation of employment with maintenance of protection in the framework of a system marked by increased occupational mobility. Fifth Challenge: International Trade and the Fundamental Rights of Workers

There is an ongoing debate on the distribution of the benefits of trade liberalization among and inside countries. Recognizing the nonautomatic nature of the process, the debate centers on whether the labor aspects that affect international trade should be regulated and, if so, how. This is a fifth challenge that has to be accepted in order to lay the bases for expansion of trade accompanied by social progress. In this section, I review the experience and the state of the debate in reference to regional integration and, more generally, in the multilateral sphere. Labor Dimensions of Integration

Three mechanisms are being applied to relate trade to labor. First, there is a mechanism in the generalized system of preferences (GSP), which allows the United States to apply trade sanctions in case of noncompliance with certain basic labor principles after an investigation of the trading partner. This is a unilateral instrument that could lead to commercial sanctions. At the other extreme, there is the multilateral European Community Charter, which does not contemplate trade sanctions. Moreover, a recent decision by the EC permits an inverse linkage: by offering tariff rebates as incentives to trading partners that respect basic workers’ rights. To a certain extent, the idea of a social charter has entered into the internal debate in MERCOSUR. Last, there is a recent intermediate option incorporated into NAFTA by means of a complementary memorandum on labor affairs; the option can involve sanctions, although only in very limited cases after a process of cooperation in which the emphasis is on resolving problems through cooperation between the contracting parties. The European Community Charter, signed in 1989, attempts to define a social order by introducing cooperation and training programs designed to generate employment and reduce regional differences by facilitating mobility, and harmonizing labor legislation, collective bargaining, and classification systems. The instrument includes 12 categories of rights, five basic ones included in the GSP, but also including free movement of people, harmonization of working conditions, social protection adapted to each country, health and safety protection, universal training, protection for the incapacitated aiming at full integration, and information and consultation with

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workers. It is a fundamentally political declaration, of voluntary adhesion, without sanctions and with only six general principles. This is exactly where the strength and weakness of declarative social charters lie. Their strength is that each country can establish its own standards independently of a charter, respecting only the general guidelines. Their weakness is that the enumeration of social aspects is general and not coercive, allowing substantial divergence between the contracting states. In the EU, where the integration process has advanced toward an economic community, the conditions of homogenization between countries are greater than in other agreements, thus a more flexible charter does not necessarily mean accepting very marked differences between the countries in the labor field. MERCOSUR is also moving in this direction. A subcommission of Subgroup 11 is examining harmonization in the areas of labor, social insurance, wages, and employment. The group has selected 21 ILO agreements for ratification by the four MERCOSUR member states in order to create a basic body of harmonized rules. The list of agreements includes some that have been ratified. In addition, the workers of MERCOSUR countries have proposed a broader social charter—European style—but so far the governments have not taken this up. The draft charter presented by the workers is justified by the need to “humanize the integration process” and establish special protection for fundamental rights, by introducing a “minimum floor of workers’ rights that automatically determine the illegality of contracts that do not comply with them.” The draft reaffirms the free movement of workers, the fundamental rights of persons and workers, collective rights, and the right to social security. In an effort to make this charter more effective, the possibility is being studied of adopting measures such as suspension of liberation of tariffs, imposition of fines, and other sanctions in cases of violation. In NAFTA the complementary memoranda (labor and environment), which are not part of the principal agreement, emphasize mechanisms of consultation and cooperation between the contracting states. The assumption is that they share the objective of social progress and that the alliance was not created to expand trade on the basis of worker exploitation. The other assumption, based on existing conditions, is that the basic principles are already incorporated into the three countries’ laws, while the degree of compliance varies according to their level of development rather than to deliberate evasion. Several areas of cooperation and consultation are included, and a permanent consultation process is set up between the contracting states. In addition, a committee of independent experts is formed to evaluate problems; and there are procedures to settle disputes in the three areas of safety and hygiene, child labor, and minimum wages. When the laws of a country in relation to products traded between the three states are repeatedly violated, any party may request an arbitration tribunal to

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examine the situation and propose a plan of action, which could eventually result in sanctions. In Canada’s case, sanctions are established by the competent national tribunal due to the federal system of government. In the United States and Mexico, it can result in suspension of benefits and fines of up to $20 million. The Debate in the Multilateral Sphere

The relationship between international trade and basic workers’ rights is now analyzed at the multilateral level. The question posed at this level is how to guarantee that the market opening leads to improved conditions of life for workers and their families. There is agreement on the importance of this subject, as shown by the debate at the GATT conference in Morocco and in its successor, the WTO, as well as in the ILO. There is consensus on how to regulate the economic aspects of the world economy in trade and financial matters and on identification of the regulatory institutions. On labor and social matters the only agreement is on the importance of analyzing the problem, but not on the need for or type of regulation, or which organization would be responsible for the regulation. However, important advances have been made on harmonizing positions. The debate fluctuates between those who see in the link between trade and labor conditions the hidden objective of introducing new forms of trade protectionism and those who are trying to prevent trade expansion through “social dumping” based on violation of workers’ basic rights. There is agreement, however, that expansion should not be at the cost of the exploitation of workers—or based on world equalization of wages and working conditions, since this would eliminate one of the developing countries’ most important comparative advantages. In the ILO, the subject is still under discussion and is being analyzed on the basis of the fundamental objective of promoting social progress backed by 79 years of accumulated experience in the adoption and control of international labor standards. This experience has two basic aspects: adhesion to international standards is voluntary, and multilateral action diminishes the possibility that a state may exercise discretionary powers over another.8 The debate revolves around two issues: first, the reasons for and against linking labor issues with the new international trade system; second, the nature and content of that link. The first aspect of the linking of labor with the international trade system is examined in its political, legal, and economic aspects. In the political sphere, the debate is about whether the absence of a labor-trade link would cause, from pressure exercised by the affected social category, the multiplication of unilateral measures to compensate differences in levels of protection

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or conditions of work, or the formation of homogenous economic blocs in the area of social protection behind a common external tariff. Even more so, when there are specific national laws intended, according to some, to promote an aggressive unilateralism in the name of promoting workers’ rights, and with no guarantee that they will not be used, under pressure from interested groups or for moral or humanitarian reasons.9

In the legal area, although the advantages of giving a binding character to the incorporation of a social and labor “dimension” to the international trade system are recognized, there is a debate on the problems posed by that linkage. In particular, there is the fact that in the GATT agreement the recourse to compulsion is relatively exceptional, and there is the difficulty of clearly establishing, in cases of alleged violation of labor rules, a relationship of causality between the violation and the damage to the international trade system. In the economic area the debate centers on the social costs. According to some, the differences in the level of social protection are a form of “social dumping” to the detriment of the more advanced countries. According to others, any attempt to remedy these differences on the universal plane would be no more than a covert attempt at protectionism aimed at depriving the less advanced countries of their principal comparative advantage, which compensates in part for the disadvantage of low productivity.10

There is agreement, however, that the most important task is to determine the labor (and more generally social) conditions that could make the progress generated by trade liberalization benefit all sectors. This subject leads to the second issue in the debate: the nature and content of the link between labor rules and the international trade system. During the debate it was agreed to postpone the subject of the introduction of sanctions (or to leave it without effect, depending on the results). Two viewpoints prevail. One is that trade liberalization is built on freedom to negotiate and contract and that the same freedom should be established at labor level. The second is that social progress should run in parallel with economic progress and the trade liberation that stimulates it. To do this, the contracting parties propose in good faith to make the social actors, particularly the workers who have produced the goods, benefit from the portion of the advantages of trade liberalization that legitimately corresponds to them. But if the intention to guarantee parallelism between social and economic progress is to have meaning and reality, its beneficiaries must have the legal and practical means to defend their interests. Advances have also been made on which labor rights are important, based on the ILO Constitution and the Philadelphia Declaration, which recognize as fundamental principles that work is not a good and that freedom of expression and association are essential for sustained progress. These fundamental rights are independent of the level of development and

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are a precondition for the exercise of other rights and progress on individual and collective conditions of work, taking into account each country’s characteristics and possibilities. As a result, four basic principles set out in seven international agreements have been established: prohibition of slave labor (Agreements 29 and 105), prohibition of child labor (Agreement 138), respect for freedom of association and the right to organize and negotiate collectively (Agreements 87 and 98), and nondiscrimination in employment (Agreements 100 and 111). An agreement on eradication of intolerable forms of child labor could be added to the list, if approved by the ILO Conference in 1999. There have also been advances in the institutional area. Both the Social Summit in Copenhagen in March 1995 and the WTO Summit in Singapore in December 1996 recognized the ILO as the institutional organization for multilateral monitoring of the area. On this basis the ILO is exploring two complementary paths. The first is to push ahead with the universal ratification of the agreements on fundamental rights, and the second is to make a solemn declaration to reaffirm them. The first gives universal application to the control mechanisms already existing in the ILO. The second introduces an intermediate path, chiefly applicable to countries that for different reasons have not ratified the basic agreements. The adoption of a solemn declaration to ratify the commitment voluntarily assumed by ILO member countries would promote compliance with the fundamental principles of labor. It is not an attempt to apply as yet unratified agreements but to reaffirm the logic of the commitments and their underlying values and principles. This generates a double commitment, first, by member states to promote the principles and, second, by the ILO to assist them in this task by all means, including technical cooperation. The rationale is to promote and evaluate progress in implementing the basic principles rather than to control the legal and practical application of the agreements. An ad hoc mechanism would be designed to monitor advances in compliance with the basic principles. In synthesis, the debate on the relationship between international trade and workers’ rights is still open and constitutes the fifth challenge. But agreement has been reached on at least three core aspects: there is the need for a renewal of the commitment by countries to enforce international provisions on the fundamental rights of workers; noncompliance with these provisions must not give rise to trade sanctions but to an international commitment of assistance and cooperation aimed at ensuring compliance; and, last, the ILO is the most appropriate organization for monitoring the level of compliance by member states. These advances have to be approved by the international community, along with others on which debate has recently begun.

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A globalization process is under way that, in the case of Latin American countries, is taking place very rapidly in four simultaneous areas. The multilateral opening set out in the GATT agreements is accompanied by a unilateral opening in the form of tariff cuts and the elimination of nontariff restrictions as an important component of structural adjustment policies. At the same time, existing schemes of regional integration are being reactivated and new ones introduced, while bilateral free trade agreements are being improved, covering almost all countries. As a result of globalization and integration, positive results are expected from the expansion of trade, which should generate higher economic growth and hence employment. Better use of comparative advantages and the relative endowment of factors should also contribute to reducing wage differentials. It is too early in the process to make a final judgment, but some tentative conclusions can be made based on available studies. First, the effects have varied according to the characteristics of each country. Second, the size of the country determines the size of the effect; in large countries the domestic market continues to be the key factor even after the opening. Third, the degree of progress in the reform process is also important; in the more advanced countries the positive effects are soon apparent. Fourth, industrial productivity generally increases, but not accompanied by an expansion in employment in the sector. Large companies tend to prune their workforces as an instrument for increasing productivity in the short term, while small firms expand their absorption of employment. Fifth, contrary to expectations wage differentials widen, with skilled workers and managers benefiting most. Last, problems of employment and income arise during the transition in the form of higher unemployment, lower-quality jobs, lower wages, and increased inequality. This chapter has identified five challenges in the field of employment policies that require action. The first arises from the need to deal with loss of independence in the formulation of employment and wage policies. Employment is closely related to capacity to compete internationally rather than to domestic demand. Higher wages have to be accompanied by changes in productivity to prevent inflationary pressures from affecting competitiveness. New demands are emerging for supranational coordination of macroeconomic policies, companies are becoming multinational, and economic policy is increasingly interrelated with social and labor policies. The second challenge consists of managing production costs in conjunction with productivity in order to increase competitiveness. However, wage and labor costs in Latin America do not seem to be a factor that is

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hindering penetration of international markets. There are, however, possibilities of reducing some nonwage labor costs, particularly those that affect unskilled manpower. The introduction of new types of low-cost employment contracts has increased the instability of the labor relationship and reduced incentives to increase productivity. More flexible contracts have to be made compatible with a reduction in the cost of dismissal that does not create instability. The third challenge springs from the increase in migration between countries. Three main aspects have to be dealt with. First, the illegal situation of many migrants prompts their social exclusion in the host countries. This discrimination can be avoided by providing opportunities for access and protection. Second, recognition of qualifications between countries is required to facilitate productive integration into the workforce with adequate pay. Last, there is a need to generate mechanisms so that migrants’ social security cover is not affected and that contributions made in the country of origin are preserved. The fourth challenge relates to internal mobility as a consequence of the transformation of production to improve international competitiveness. This requires policies designed to improve employability through retraining of labor capacities without loss of labor and social protection. A suitable combination of active and passive labor policies can be successful in meeting this challenge. Finally, the fifth challenge relates to labor regulation as an instrument for transforming the benefits of trade expansion into social progress. This ongoing debate is advancing toward common positions based on four premises. First, the link between trade and labor conditions must be flexible and not subject to sanctions. Second, there must be concentration on the fundamental principles of labor. Third, although these principles are binding on all countries, their legal commitments should continue to be regulated at the multilateral level and by voluntary adhesion. Fourth and last, the ILO possesses foundational advantages and experience that can be used to meet this challenge. Notes

1. This work is the result of a series of investigations made with Daniel Martínez, regional advisor for Latin America and the Caribbean, ILO, who also participated in its writing. 2. This section is largely based on information contained in Panorama Laboral ’97, no. 4, ILO Regional Office (Lima: ILO, 1997). 3. R. Páez de Barros, Brasíl: Apertura comercial e mercado de trabalho, Working Document No. 39, ILO Regional Office (Lima: ILO, 1996); P. Meller and A. Tokman, Chile: Apertura comercial, empleo y salarios, Working Document No. 38, ILO Regional Office (Lima: ILO, 1996); J. Saavedra, Perú: Apertura comercial,

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empleo y salarios, Working Document No. 40, ILO Regional Office (Lima: ILO, 1996). 4. J. M. Camargo et al., Apertura comercial, productividad y empleo en Argentina, Brasil y México (Lima: ILO, 1998). 5. D. Martínez and V. E. Tokman, “Costo laboral y competitividad en el sector manufacturero de América Latina,” Costos laborales y competitividad industrial en América Latina (Lima: ILO, 1997). 6. McKingsley Global Institute, “Latin American Productivity,” in Latin American Weekly Report, June 1994. 7. ILO, Panorama Laboral ’97, 1997. 8. See ILO, Preservar los valores, promover el cambio, Report of the Director General, M. Hansenne, to the International Labor Conference (Geneva: 1994); ILO, Informe del Consejo de Administración a la Conferencia Internacional del Trabajo (Geneva: 1994); and ILO, Reply to the Director General, M. Hansenne, to Debate on His Report, International Labor Conference (Geneva: 1994). 9. See ILO, Document of the Working Group on the Social Dimensions of the Liberalization of International Trade, ILO Governing Body, 1994. 10. Ibid.

Bibliography

Camargo, J. M., et al. Apertura comercial, productividad y empleo en Argentina, Brasil y México. Lima: ILO, 1998. ECLA, 1995. América Latina y el Caribe. Políticas para mejorar la inserción en la economía mundial. ILO. Panorama Laboral ’97, No. 4, ILO Regional Office. Lima: 1997. ———. Preservar los valores, promover el cambio. Report of Director General M. Hansenne to the International Labor Conference. Geneva: 1994. ———. Informe del Consejo de Administración a la Conferencia Internacional del Trabajo. Geneva: 1994. ———. Reply by the Director General, M. Hansenne, to Debate on His Report, 1994. International Labor Conference. Geneva: 1994. ———. Document of the Working Group on the Social Dimensions of the Liberalization of International Trade. ILO Governing Body, 1994 McKingsley Global Institute. “Latin American Productivity,” Latin American Weekly Report, June 1994. Martínez, D., and V. E. Tokman. “Costo laboral y competitividad en el sector manufacturero de América Latina,” Costos laborales y competitividad industrial en América Latina.” Lima: ILO, 1997. Meller, P., and A. Tokman. Chile: Apertura comercial, empleo y salarios. Working Document No. 38, ILO Regional Office. Lima: ILO, 1996. Páez de Barros, R., et al. Brasil: Apertura comercial e mercado de trabalho. Working Document No. 39, ILO Regional Office. Lima: ILO, 1996. Saavedra, J. Perú: Apertura comercial, empleo y salarios. Working Document No. 40, ILO Regional Office. Lima: ILO, 1996.

13 The Sustainability of Development Alfredo Eric Calcagno and Eric Calcagno

In the 20 years between the Stockholm conference in 1972 and the Rio de Janeiro summit in 1992, ecology assumed a transcendent role in culture, politics, and economics, having been a subject of scant significance until then. The dominant view of the unlimited conquest and exploitation of nature had come to end. Nature was no longer infinite. Since then, any good international report has to contain the words sustainable, sustainability, and development, combined in so many ways that it is sometimes legitimate to wonder whether the true scope of the word sustainable and its derivatives are really understood. For this reason, we begin with an examination of the concept of sustainability. We then analyze three events that are jeopardizing the continuity of human societies, at least as the societies have been known until now: climatic change, depletion of the ozone layer, and different forms of pollution. In the third part, we examine the causes of the degradation of the human environment as a consequence, in many cases, of short-term economic behavior. In this area the neoclassical approach clashes with the ecological theses. Next, we discuss the fundamental dilemma of the limitations of shortterm economic gains when they cause deterioration of sustainability. This leads to the problem’s core, which is basically moral: how to promote respect for life as a higher value than the advantage of profit or power. The solutions, if they exist, exceed the merely circumstantial. Therefore, we propose to advance a more precise definition of sustainability, since the mere enunciation of the principle and the almost totemic reverence shown it in international forums is insufficient. The principle of sustainability deserves its own rationale—a methodology of action by which it can operate. We are very far from a single solution to the problem. We think it useful to present several scenarios in which the dynamics of sustainability and development produce different types of societies. Last, we make some conclusions that, in synthesis, point to the impossibility of resolving the problem in the framework of dominant neoclassical 289

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thought and the importance of the moral position that considers that the solution to the problem of environmental degradation as not economic but political. Sustainable Development

An Exacting (and Original) Analytical Framework: Human Survival

In general, humanity’s economic, political, and cultural commitment has been manifested synchronically: action urged by the immediacy of the moment. This has been the case with the ideologies, passions, and religious conflicts that have exacted bloody results throughout the 20th century. The principal contribution of sustainability is that it departs from the immediate and considers the long term. The end of this century has seen the appearance of a new form of being-in-the-world, perhaps more related to responsibility than to diachronic commitment, and considering problems from the perspective of the future, no longer imagining the best of all possible worlds but avoiding the worst of the present world. The clearest example is the change in the global danger to the survival of the planet. During the Cold War, the mutual destruction with which the nuclear powers threatened each other could have meant the end of life. Today, it is the unlimited development of human society itself that is jeopardizing life on this earth, or at least the type of social development that is structured on the existing relationship of forces. Given the physical basis of human nature, expressed in growth and reproduction, and the cultural requirements of life in society, the diachronic commitment expresses the responsibility of human beings for others today and in generations to come. In short, humanity’s first duty is to itself, now and in the future. This way of viewing the problem has been well analyzed by Hans Jonas, who argues that nature could not have taken a bigger risk than letting man be born. . . . In this century the point was reached—foreseeable for a long time—at which the danger becomes clear and critical. Power in association with reason carries the responsibility within itself. This was always obvious with respect to the inter-subjective dominion. The fact that the responsibility has recently gone beyond to include the state of the biosphere and the future survival of the human species is simply provoked by the extension of power over these things, which is primarily a power of destruction.1

Hence, Jonas’s requirement is to “work in such a way that humanity exists after you for the greatest possible time.”

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He adds that future humanity, which we have to take care of, is extremely fragile and delicate. Prudence must be exercised, even in refraining from action when it might endanger future survival. So, by extension, we also have to care for our immediate surroundings, which means making development sustainable. This point of view may seem original, that the principal enemy of humanity does not lie only in disease, natural disasters, or death but resides in humanity itself. This takes us back to old , philosophical questions, such as Omar Khayyam’s reflection that “heaven and hell are in you” and Hobbes’s not very poetic, but threatening and cynical, “man is the wolf of man.” In this situation, it seems we must begin with the principle of sustainable development and understand what it means in practice. Definition of Sustainable Development

The dictionary of the Spanish Royal Academy defines the verb develop as “progress, the economic, social, cultural or political growth of human communities.” Sustain is defined as “to conserve a thing in its being or state” and “sustain a thing so that it does not fall or reverse direction.” These definitions contain the basic elements of sustainable development: progress in all its aspects and what to do so that progress heads toward the future, without falling or reversing. The two requirements that follow are that integrated growth is not limited to the economic sphere and that continuity and values are respected. The challenge is to use “science with a conscience.” There are over 20 definitions of sustainable development, emphasizing different elements.2 The official one is that of the World Commission on the Environment and Development (Brundtland Commission), that which ensures “that the needs of the present are satisfied without compromising the capacity of future generations to satisfy their own needs.” It is a useful definition because it covers the temporal dimension of the problem, but it appears to be biased toward the strict preservation of natural resources: it does not consider the kind of needs that have to be satisfied now and in the future. In the face of growing environmental depredation and irrational exploitation of natural resources, this line of thought maintains that development should not violate certain natural laws, thereby preventing environmental degradation that results in the deterioration of the very basis of life. A deeper analysis leads to consideration of the consequences of development in time and space, over and above the activity involved. This does not mean modifying resource allocation but, rather, a different kind of growth. It means replacing the mechanist approach to development based on growth rates with a qualitative approach not limited to asking how much, but also how, when, where, for whom, and with what present and future consequences. This brings us to the problem of the structure of power.

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These criteria can be synthesized in two phrases. First, “the true challenge of economic development is not related to the speed at which a country can grow, but to the level of welfare the country can achieve by growing more quickly.” Second, “while the traditional theory of growth asked what the optimal velocity for accumulating capital should be, the modern approaches to sustainability of development ask about what forms of capital should be accumulated and for how long.”3 Threats to Global Sustainability

General Considerations

Growth, development, and sustainability are interrelated ideas and are concepts that have to be systematically confronted with reality. There are two principal problems of the sustainability of development: (1) environmental pollution, which in the long run threatens human survival, at least as we know it, and in the medium term can cause ecological catastrophes; and (2) the excessive extraction of energy or material resources resulting in their depletion or destruction. Both these threats highlight a basic conflict between the rules of the market that encourage maximum profit taking, with no restrictions of any type, not even environmental and the general welfare for the present and future, whose priorities are the preservation of the environment and the rational utilization of natural resources, even at the cost of lower corporate profits. As already noted, this is a new problem. This is the first time in history that we are not starting from an assumption of unlimited natural resources. The present error consists in trying to apply old formulas or failed concepts to new kinds of crises. The old controversies over Malthusianism are returning in a new form, no longer applying only to food shortages but to the general availability of the natural resources needed to sustain acceptable development. These arguments conflict with the impossibility of supplying humanity sufficiently without affecting the relationship of existing political forces. A key issue now is that of “exporting” the means of generating pollution by the developed countries. If the most densely populated developing countries accept these means, resource depletion and pollution generation could reach unsustainable extremes. And there is no solution to this issue in maintaining underdevelopment. This would not only continue the existing inequitites but also expand forms of poverty-linked pollution. It could be argued then that environmental and social sustainability are incompatible, insofar as the latter depends on a certain amount of equity in the long term. If development in its present form is polluting, the solution is not to hold up the development of countries that are still relatively unpolluted but

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to combat pollution. This simple argument is difficult to adopt because it goes against the concept of unlimited corporate profits. The fundamental issue is whether moral and political action limit any economy to reduce pollution in both developed and developing countries, even though that limit may bring significant increases in cost. Environmental Pollution

The principal factors affecting the environment in the long term involve air, water, the earth, and cities.

Air. The climatic changes that are changing the composition and temperature of the atmosphere have serious consequences for life. The gases that cause global warming are also those that in the necessary amounts prevent the land temperature from falling to –18° C (0° F), which would make human life impossible. If the amount of gases is altered by artificial, “greenhouse” emissions, the average temperature could increase by 3° C (6° F) to 7° C (12° F) by 2100, with disastrous consequences. The ocean level would rise significantly—up to 20 centimeters (almost 8 inches) from melting ice and 50 centimeters (about 20 inches) from thermal dilatation—flooding many densely populated coastal areas.4 Along with the sea level, watercourses and the frequency of droughts and floods would be altered, affecting agriculture, forests, rain and bio diversity. Agricultural production could conceivably be redistributed, as the desertification of existing arable areas took place, with cultivable land opened up in areas that are now cold and forested. The long-term consequences cannot yet be measured but, as a first step to tackling the roots of the problem, it is important to prevent the situation from worsening. The principal air pollutants are sulfur dioxide, nitrogen oxide, volatile organic compounds, particles (including iron), carbon monoxide, and benzene. “The deterioration of air quality can be considered as the result of the interaction between natural characteristics (atmospheric stability, temperature, wind speed, etc.) and social characteristics (size and density of population, atmospheric pollutants emitted by transport, industry, combustion, etc.). The contribution of motor vehicles is particularly alarming.”5 Another serious atmospheric problem is the depletion of the layer of ozone, an element that is infinitesimal in volume but indispensable for life because it protects us from the most harmful ultraviolet rays emitted by the sun. Emissions of chlorofluorocarbons (CFCs), coupled with the chemical conditions of the atmosphere at the South Pole, are threatening the ozone layer in a way that is still unpredictable. The CFCs take several years to reach the high atmosphere, and about 90 percent of CFCs emitted are still in the lower layers of the atmosphere, meaning that their full effect has yet to be felt. It is not known what will happen when they reach the higher layers. The developed countries produce

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three-quarters of the CFCs used for aerosol gas, refrigerator fluids, elements to inflate plastic foam, and solvents for the electronics industry. Production of CFCs continues even though their terrible consequences are well known. Along with the long-term effects of pollution already mentioned, there is the atmospheric pollution caused by vehicular traffic, electricity production, and industry in general. At present, atmospheric pollution is intense in large cities in industrial and developing countries. In Latin America, the seriousness of the situation in Mexico City and Santiago, Chile, is such that the authorities have been forced to adopt immediate corrective or palliative measures. Several countries are now applying measures to reduce the emission of volatile organic compounds.

Water. The oceans contain 97.1 percent of the worlds’ water. The water found on the continents accounts for only 2.59 percent of the total, and most of it is unusable (in ice, snow, and underground water). Human beings and other living organisms can only use 0.014 percent of the water.6 With respect to usable water, the dangers are deterioration of quality and overexploitation (in relation to surface and underground water) that results in a reduction or salinization. There is a need to prevent excess water consumption as well as pollution from the intensive use of nitrates and phosphates and discharge of industrial waste and domestic garbage. Coastal areas are worst affected by sewage, hydrocarbons, organic compounds, sediment, and detritus. Some countries do manage their coastal regions to preserve the environment: when accidents happen, such as wrecked oil tankers, all the instruments of environmental protection go into action—but these are merely palliative.

Soil. Problems of soil quality involve its physical, chemical, and biological degradation, which is generally caused by agriculture, industry, urbanization, and tourism. Soil erosion can be caused by water, wind, or desertification processes resulting from forest clearing or irrational agricultural exploitation. Soil pollution can be caused by heavy metals, excess nutrients, acidification, or organic pollutants. The acceleration of erosion has provoked desertification, especially in arid or semiarid areas, that comes from overgrazing and cutting of trees and scrub to provide fuel for cooking and heating. This is particularly important because most of the fuel used in the least developed countries comes from vegetable charcoal. Deforestation has affected tropical forests. It is argued that the depletion of the Amazon Basin forest constitutes a danger for world ecology. It has been calculated that deforestation is responsible for 15 to 30 percent of man-made CO 2 emissions. Moreover, an estimated 2 million different species live in the forests and 4,000 to 6,000 species disappear every year

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because of deforestation.7 These processes substantially reduce the possibility of analyzing, studying, and benefiting from this genetic heritage.

Cities. Urbanization has intensified all over the world, and almost never in a rational way. It has aggravated the problems of atmospheric pollution, noise, and traffic. Developing countries have the added problems of water pollution and nonexistent sewage systems. A special area is the effect of waste on the environment, during both the production and treatment stages. The effect of waste grows with urbanization and at its most harmful pollutes both soil and water. The principles for its treatment have been in enumerated by the EU: (1) reduce its flow; (2) recycle everything possible; (3) incinerate what cannot be reused; (4) treat the effluent resulting from incineration; and the (5) store everything that has not been fully treated in protected places. A particular issue is the waste generated by atomic energy generation. Several developing countries have rejected attempts by developed countries to set up nuclear waste disposal sites; but, given the secret nature of such operations, it is not known how many developing countries have accepted such arrangements. The Economic Dimension of Sustainability

Almost all countries have taken some political measures to control threats to the environment, at least to prevent the most immediate catastrophic consequences. But compliance is far from effective, though this is not simply a matter of fate or destiny. The reasons for insufficiency of control involve the most important material human activity: production of wealth. Here we analyze the differences among ecology, economics, and the market. The conflict between profit and environment leads to the consideration of the means of production and consumption. Article 8 of the Declaration of Rio de Janeiro emphasizes the need “to reduce and eliminate nonviable means of production and consumption and promote appropriate demographic policies.” At the theoretical level, opinions differ on the causes and effects of environmental degradation, and consequently on appropriate policies. Here we will only mention the views that are the most mutually hostile: neoclassical and “ecological” economics.

The Neoclassical Approach

Neoclassical theorists recognize the deterioration of the environment produced by economic activity exercised without limitations; but the theorists maintain that it is not important in a system of competitive market prices. They argue that although some natural resources may run out, substitution

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among the factors of production takes place along with a strong contribution from technological progress. Thus future generations will be able to enjoy a growing “natural capital” because the volume of capital and scientific and technical knowledge will increase, even though some natural resources will diminish. Accordingly, problems arise because of anomalous situations determined by “external balances” that are difficult to evaluate. The solution lies in the reestablishment of trade in situations where it does not exist or is incomplete. Neoclassicists even suggest an “optimal pollution,” based on a cost-benefit analysis determined by the intersection of the marginal social costs and marginal benefit curves (social cost being influenced by a pollution tax on companies).8 The market mechanisms used to combat pollution are generally based on the principle that “the polluter pays.” Here a number of mechanisms are used. First, there is payment for the cost of keeping the environment clean, including waste disposal, water decontamination, and recovery or elimination services (e.g., used oils, mercury, and cadmium batteries). Second, there are fiscal measures such as taxes on polluting products and exemptions for environmentally friendly products; for example, CFCs are taxed most and lead-free gasoline least. A third procedure is a market in pollution rights that is organized by the polluting firms. In this the public authority sets a ceiling on pollution, and under this ceiling companies receive permits to emit a certain quantity of pollutants. The permits can be sold or bought. Companies can choose between paying pollution taxes or buying a permit from polluters that have not reached their own limits. This system is established in the U.S. Clean Air Act of 1969.9 Ecological Economics

Criticism of the neoclassical theses. Against the “market” position, which is now the dominant view (although with some refinements), there are “ecological economics” that reject that view. Ecological economics ask what the “market solution” is. Could market economics in fact be worsening the present situation, in which the environment—a good that ought to be collective—is subject to private appropriation and the logic of economic exploitation? Rational and selfish individuals—whose only aim is to maximize their personal, family, or business utility—cannot be expected to do anything that would lessen their profits. First, the individuals would have to abandon the basic assumptions of their theoretical construction, and second, they see that ecological logic is contrary to competitiveness. Reducing emissions that generate pollution is costly. Lowering exploitation of natural resources because of consideration for future generations has great moral value but has nothing to do

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with the market. On the contrary, this would mean giving up immediate profits and offering advantages to less scrupulous competitors who would replace the more scrupulous actors in the market. The ecological thesis maintains that the free play of the market results in the “natural selection” of conducts that are most harmful to the environment. As long as the scarcity of a natural resource is not felt—and air, water, and ozone continue to be “public goods”—markets can ignore the predatory nature of a modality of growth. “The price mechanism is not apt for spontaneously redirecting economic activity in the sense of a more moderate use of the products of subsoil or common environmental goods. The structure of relative prices offers information on relative scarcities at any given time, but it cannot indicate long-term scarcity.”10 “The bio sphere, which is not aware of the rules of economic optimum, has its own modalities of adjustment”11 operating in its own time, which can be centuries (or millennia in the case of atomic waste). What interest rate, what risk analysis can be applied for such a long horizon? The problem is that when scarcity or pollution occurs it may be too late to correct. Once again, the temporal dimension is the key factor in decisionmaking, and is generally ignored. Under the market approach, not only does the quality of life of most of the existing population deteriorate but that of future generations is compromised. The market economy has no solution for this problem. In relation to exhaustible resources or long-term external effects (such as an increase in the carbon dioxide in the atmosphere), “the methodological principle that the allocation of resources must respond to the preferences of economic agents comes up against an ontological difficulty: many of the economic agents are not yet born, and cannot therefore express their preferences.”12 The response to the ecological problem has to come from other actors—not the selfish individuals postulated by dominant economic theory—who introduce noncommercial values and a much longer time horizon. In this context, states have to act because they represent not only national and popular interests but those of society universally affected by environmental deterioration.

The ecological thesis. Ecological economics postulates that the environment falls into the category of a “collective good.” The environment cannot be appropriated, it is not exclusive, it is often free, and it contributes to overall community welfare. The ozone layer, for example, is not produced, it does not belong to anyone and it is useful to everyone (with no need to exclude anyone) although (and above all because) it is not consumed. The environment cannot be considered to be a “pure” collective good, because its consumption by some can destroy the good or the qualities that make it attractive.”13

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This is a reassessment of the economic interpretation that reduced ecology to a few restrictions on the market. First, it restores a global approach in which socioeconomic systems become subsystems open to the planetary ecological system, in an inversion of the hierarchical systems imposed by neoclassical economics. Second, it is argued that socioeconomic and natural systems are in continuous evolution and are modified reciprocally. Ecology puts the accent on the long-term aspect of this relationship. Additionally, it analyzes “industrial metabolism,” which studies the exchanges of material and energy between socioeconomic systems.14 The operational principles of an ecological economy were defined by Herman Daly: “(1) rates of depletion of renewable natural resources must be equal to their rate of regeneration; (2) rates of emission of waste must be equal to the capacity for assimilation—the load capacity—of the ecosystems where the waste is dumped; (3) exploitation of non-renewable resources must be at a rate that equals replacement by renewable resources.”15 Economics and ecology. The differences of approach, realities, and solutions between economics and ecology are not new. Juan Martínez Alier recalls the difference that Aristotle proposed in his Politics between economics (the study of the material supply of the household, oikos, or the city, polis) and “crematistics” (the study of the formation of market prices). For Aristotle, the supply of the oikos and the polis should not be regulated by prices. “Aristotle did not use the word “ecology,” whose root is the same as economy and which was introduced in the 19th century, but the difference between economy and “crematistics” is exactly the difference we now make between human ecology and economics, between the study of the use of energy and materials in ecosystems where men and women live, and the study of market transactions. The sense that Aristotle wanted to preserve for the word economics—as opposed to the expansion of trade and changes in social relations that this implied—is precisely the meaning that the term “human ecology” now has. . . . Two examples: ecological economics asks if the market sets the price of oil at a good level. Is it perhaps too low from the point of view of its conservation for future generations? It also asks if the price industries have to pay to dump unrecycled waste in the environment is too low. . . . The market cannot allocate exhaustible resources with the participation of the those who are yet to be born.16

What Martínez Alier is expressing from the writings of Aristotle is the confusing of the production and reproduction of human society with the unlimited production and reproduction of wealth. It would be naive for us to advocate a return to the agricultural values of ancient Greece, but we cannot fail to note that present means of production and consumption result in environmental degradation, to such a

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point that the very sustainability of development is in doubt. In the developing countries, this general statement has to be qualified by concrete facts. First, there is the pollution that all developed countries create, which is added to another kind of pollution created by underdeveloped nations; but, at the same time, it is possible to distinguish local problems from regional or global ones. As might be expected, environmental problems vary according to a country’s degree of development. The most developed countries are the biggest polluters: 25 percent of the world’s population lives in developed countries, consuming 80 percent of the world’s resources and producing an analogous percentage of waste. The United States, with 4 percent of world population, is responsible for 22 percent of carbon dioxide emissions. Its emissions per capita exceed by five times the world average (see Table 13.1). Countries such as China and India are among the world’s five largest polluters because of their high populations, but their rates per capita are low. “The topics that dominate the international agenda on the environment—acid rain, the greenhouse effect, or depletion of the ozone layer—are all the responsibility of the countries of the North.”17 In the particular case of CO2, Table 13.1 shows emissions by country, based on global figures for 1994. By the way of synthesis, we see that existing environmental problems afflict the most important areas of production and reproduction of human life in society. The problems are also disturbing in that the length of time of their effects does not correspond to the time span of their causes. This Table 13.1 The Most Prominent Polluting Countries: Annual CO2 Emissions, 1970 and 1994 Country

United States China Russia Japan India Germany United Kingdom Canada Ukraine Italy Mexico Poland World total

Millions of Metric Tons

1970

1,155 211 — 202 53 275 175 89 — 78 29 83 4,084

1994

1,387 828 441 303 236 220 150 122 112 107 98 92 6,200

Tons per Capita

1970

5.64 0.26 — 1.94 0.10 3.53 3.13 4.19 — 1.45 0.57 2.55 1.10

1994 5.32 0.70 2.99 2.43 0.26 2.70 2.56 4.18 2.17 1.87 1.06 2.41 1.10

Source: Gregg Marland and Tom Boden, Oak Ridge National Laboratory, Tennessee, July 1997; reproduced from the Internet.

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lag raises concerns about the interest of decisionmakers and members of the public in solving problems that, while alarming today, will be much more serious in half a century. From the serious consequences for the environment, we have moved to the economic structure that produces them, and we finally arrive at the political problem.

Political Solutions

The Political Problem

Environmental problems are a focus of public attention. In many countries “green” political parties have been formed, concentrating their programs on protection of the environment, and the political platforms of many other parties have incorporated these principles. On an international level the organization Greenpeace, created in 1970, has increased its influence through technical studies and political action. Second, the environment has been the subject of many international agreements.18 The most important are those on reduction of hazardous waste, biological diversity, reduction in world gas emissions related to the greenhouse effect, and elimination of substances that deplete the ozone layer. We now look at some of these. The Basel Convention on control of cross-border movements of dangerous waste and their elimination was signed in 1989 and has been ratified by 105 countries. It permits restrictions that can go as far as a total ban on imports and exports of certain classes of listed wastes. The Convention on International Trade in Endangered Species (CITES), signed by 134 countries, was adopted in Washington, D.C., in 1973 and amended in 1979 and 1983. It bans trade in species threatened with extinction and regulates the trade in endangered species. The Convention on Biological Diversity was presented for signature at the UN Conference on the Environment and Development (1992); at the end of 1996, 166 countries had signed, not including the United States. Its aim is “the conservation of biological diversity, the sustainable use of their components and just and equitable participation in the benefits derived from the use of genetic resources.” A series of measures for the conservation, identification, and monitoring of biological diversity are established, at the level of genes, species, and ecosystems. The UN Framework Convention on Climate Change came into effect in 1994, and at the end of 1996 had been signed by 163 countries. Its objective is to protect the climate. According to Article 2 of the convention, governments are committed to measures to “stabilize the concentration of greenhouse gases in the atmosphere to a level that prevents dangerous

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anthropogenic interference in the climate system. This level should be achieved in a period sufficient to allow ecosystems to adapt naturally to climate change, ensure that food production is not threatened and allow sustainable economic development to proceed.” In December 1997, the Kyoto Conference in Japan brought together 159 countries for the signing of a protocol on climatic change, in which 38 industrialized countries agreed to make average reductions of 5.2 percent in emissions of six greenhouse gases between 1998 and 2012. This means reductions of 8 percent for the EU, 7 percent for the United States, and 6 percent for Japan. These measures will not solve the problem but will delay the arrival of the critical point, which seems to be the duplication of the present concentration of toxic gases. The Vienna Convention on Protection of the Ozone Layer (1985) and the Montreal Protocol on Ozone-depleting Substances (1987), together with their amendments (London, 1990, and Copenhagen, 1992), progressively eliminate production and consumption of the ozone-depleting substances, especially CFCs. The Montreal Protocol was signed by 160 countries, and the London and Copenhagen amendments by 111 and 62 countries, respectively. These treaties reveal a current of international opinion that is responsive to the issues of ecology and sustainability. However, the treaties are only palliatives, since there are no effective means of regulation. The agreements do not attack the central problem, which is the style of development of the highly industrialized countries. First they try to preserve a power relationship, and second they ignore the interests of other countries—especially the least industrialized—which are attempting to evolve to more advanced levels. They also avoid analysis of the economic problem from perspectives other than those of the industrialized countries. This will be the subject of the next section.

Convergence: Development Styles, Quality of Life, Political Systems

Taking only those ecological problems regarded as most important, the results of actions by international authorities and the most developed countries are disappointing. There is a strong disproportion between the consequences of the unlimited exploitation of natural resources and the limits proposed to establish a form of use resources that is consistent with the principle of sustainability. As many examples confirm, the hegemonic economic order accepts modifications that slow the growth rate of the principal factors of pollution; but at no time is the primacy of sustainability, which is an essentially moral principle, placed over short-term economic profits. The approach confirms the style of development that causes the instability of nature but

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legitimizes immediate benefits—and only agrees to pay part of the costs of environmental deterioration in the medium and long term. It is a commerce-based view, which in the best of cases repairs direct damage but does not undertake to produce and consume in a way that is not harmful to the environment. Ecological catastrophes do not disappear by compensating those immediately harmed, whether neighbors whose water is polluted or coastal populations afflicted by the “black tide.” Further, in the case of the greenhouse effect and depletion of the ozone layer, all humanity is harmed now and in the future. The discussion should be centered more on causes than on consequences, more on the problem of the means of production and distribution of wealth than on the number of centimeters waters may rise in a global melting. This concept is reinforced by the director of UNEP, Mostafa K. Tolba: “The two basic causes of the environmental crisis are poverty and the bad use of wealth: the world’s poor are obliged in the short term to destroy the resources on which their subsistence depends in the long term, while the rich minority make demands on basic resources which are unsustainable in the long run.”19 This type of debate on the limits of growth increases the confusion. It calls attention to the limited resources of the planet and the imbalance between population growth and the use of resources; but it does not relate to the social and political structures that cause these imbalances. The planet is really limited, but scarcity is a reality which exists and which is created by the power structures. In other words depletion of resources has to do with the question of who controls, and who establishes the rules of consumption and styles of development. . . . Private property without social control, the prevalence of individual interests over the public interest as well as the profit incentive, has a great part of the responsibility for the present environmental and ecological imbalances.20

We also know that “environmental pollution and the use of the world’s resources depend more on patterns of consumption and the lifestyle in the developed countries—and their spread to developing countries—than on the growth rates of the population of the latter.”21 This then in all its crudity is the problem of power. The Moral Aspect

The panorama of sustainability is crossed by different kinds of dynamics. In the economic aspect, interests created by styles of production and consumption wield an influence backed up by the might of the industrialized economies. In the political field, sustainability is characterized by a wide range of positions. The overall picture is confusing, marked by scientific advances, international encounters, and differing views of the crisis.

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First and foremost, it should be mentioned that the economic sphere and the political order are different and separable, at least for the purposes of analysis. Ever since the existence of capitalism, economics has been the activity devoted to creating the greatest quantity of wealth in the least possible time. In the age of globalization, economics’ specificity is that its principal agents make their decisions at planetary level. Thus, the economic order generates determined events at the world level, where the political order is less organized than the economic, and is an order that favors the tyranny of short-term profitability at any cost in natural resources. Proof of this is the limits on decisions taken to preserve the environment. The developed capitalist models have demonstrated great versatility and adaptability over time for the production of profits, partly due to the systematic incorporation of new technologies and above all, because the economic order does not recognize any type of internal limits on the means of production of wealth. The logic of the economic order simply ignores the sacrifice of the environment (or at least its commercial exploitation), as well as unlimited automation of technology (although this may cause serious harm to humanity, as was the case of the toxic gas tragedy in Bhopal, India, in 1984 which caused 3,000 dead and 260,000 injured). Economic activity establishes the material conditions of society, but without any type of moral dimension. In turn, the political order, at national and international levels, is a structuring of different social factors whose purpose is to produce and reproduce power. The political system, the system of selection and advancement of the elites, and relations between rulers and ruled are the principal aspects of the political level. Like the economic area, it is incapable of producing an idea of global purpose. The political and economic orders are closed, each one guided by its own nature: the political by power and the economic by profit. The economic area does not incorporate political and moral restrictions into its mechanics, and the political does not incorporate moral impediments. Each order is structured and acts according to its own logic without any internal limits. According to the logic of science and technology, anything that science and technology can do will be done (including genetic manipulation of human beings) even though this may be repugnant to morality and society. To drive profits to their limits, economics would, if it were possible, resort to financial speculation, drug trafficking, the most inhuman forms of exploitation of workers, and extreme depredation of natural resources.22 We do not want to offer a pessimistic view of the relationship between sustainability and development or accuse the economic order of immorality. (In essence it is amoral.) But it is essential to have a view of reality before taking action. If we think that the problem of the environment will be solved by the logic of profit, we are headed for disaster. Similarly, power

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is not directly related to the environment: the accumulation of power is unaffected by climate change, the ozone layer, and pollution. Economists and politicians will not include environmental issues in their agenda of problems if there is no awareness of the moral dimension of sustainability. Here the moral and collective imperative of the survival of the human species has to be brought into play, above the logic of the operation of the economy and politics. The moral stance must be to put curbs on both, in the name of the higher value of human survival. In the hierarchy of values the highest value is life. This does not mean the value of the form and being of all living things . . . but the narrowest value of life as the essential ontological basis of the subject and the moral being and bearer of values, that is of the person. . . . A second group or series of values are worldly values that are not inherent in the subject, but which are values “for” the subject, and adhere to the object, being of things and of the surrounding world.23

How can the preeminence of life be guaranteed? If sustainability were a product of economic and political activity because it promoted growth of wealth and power, we would not have to do anything. The best thing would be to sit back and wait for simple human selfishness to generate sustainability. But we know very well that wealth is not created by protecting the environment and power is not accumulated by defending sustainability; to use only economic arguments or political reasons is to condemn oneself to going around and around the problem and never finding a solution. The higher level has to be considered, a broader sphere that covers and goes beyond the economic and political areas. This places the problem of sustainability in the human order, which is the moral. This third order is what exists in all society along with the economic and political orders. It does not generate wealth or power but produces meaning. It is the field of ethics, whose fundamental question is how to live. Here is morality, which asks what one should do. The two levels are complementary and inseparable. Far from representing a mere intellectual entelechy, questions of ethics and morality structure human actions through act or omission for the present and future. In relation to sustainability, to speak of the right of future generations and of development without abuse, perhaps without consuming as we know it today (as the fire consumes the forest), implies a series of determinations, choices, and decisions. These three orders—the economic, political, and moral—are not separate, but interact in all human situations; they are used as categories of analysis in this work, not for normative reasons but as explanations. The problem of sustainable development does not belong to the economic or political areas: it is a problem of the meaning of humanity.

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Possible Scenarios

We have presented three different approaches to the relationship between sustainability and development, each with its basis in economics, politics, and morality. The scene is now set, and the actors and their arguments are known. But the overall scheme is absent; this is constructed day by day, by act or omission, in the decisions that are or are not made. We now present four possible scenarios for developing countries, four ways of dealing with sustainability and development. Not Development, Not Sustainability

There are cases when economic stagnation, social inequality, and environmental deterioration are all present at the same time. Normally, when economic growth slows or halts the poorest groups are most affected, and those who control economic and political power redistribute income in their own favor. At the same time, at national level, the crisis in the balance of payments provokes an overexploitation of natural resources for export; and at local level, poverty obliges consumption of the resources that are immediately to hand, especially, the felling of trees for fuel. This was the situation in Latin America in the 1980s, when the region’s per capita gross domestic product recorded an accumulated fall of 7.9 percent; gross domestic capital formation as a percentage of product fell from 24.7 percent in 1980 to 15.7 percent in 1990; $210 billion were transferred abroad and the external debt soared from $228 billion in 1980 to $433 billion in 1990. During the “lost decade,” in relative terms, there was a massive jump in payments to foreign factors due to servicing the external debt. This item was very small in 1970, except in the case of Venezuela. The wage earners’ share plunged, with the exception of Brazil. And the share of gross operating surplus received by nationals—the earnings of local companies—increased in Argentina, Mexico, and Venezuela and fell in Brazil and Chile. The reduction in wages reflected a change in the structure of employment: the industrial workforce contracted and the informal sector grew, especially services with low productivity. Another effect was the depletion of natural resources: 71.8 million hectares (about 178 million acres) of forestland were lost between 1970 and 1987.24 Sustainability Without Development

There are many examples in history of sustainability without development, found even in entire countries and social groups. Absence of development

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means a society that is not structured around permanent increases in production even though people are able to satisfy their needs. A typical example is in the indigenous communities in Guatemala that refused to increase agricultural production because “you should take from Mother Earth no more than is necessary to live.” A tribe on the coastal plains of Cameroon regarded the excessive accumulation of wealth as a sign of witchcraft (perhaps not an entirely misguided idea); to avoid punishment—death—the accused had to give away his goods. In the Kwakiutl societies of the Pacific Northwest in the United States, the accumulation of wealth was dishonorable; far from measuring social success as in mercantile societies, it was a sign of miserliness. Instead the potlatch was practiced: prominent persons gave away or destroyed goods as a means of limiting the accumulation of wealth in a few hands, which could threaten the social order.25 These examples reflect realities where sustainability takes precedence over development, at least in the accepted terminology. Perhaps these examples are only a witness to different ways of managing the problem and cannot be replicated outside structures, often agricultural, where change is slow and integration into their respective countries is slight. In much more recent times, the need to stop or redirect growth has been recommended in order to not deplete natural resources. If the industrial countries continue their present practices, resources will be used up in the medium term; but if the people of developing countries like China and India consume a half or a third of what is consumed in the United States and Europe, natural resources will run out much more quickly. The present level of consumption by the elites in the developing countries is similar to that of the rich in the developed countries. This cannot be even remotely generalized to all the population: the consumerist model is necessarily exclusive, and in the developing countries more so than in the developed, particularly in heavily populated countries. In recent times, the dilemma was put in these terms: either the advanced countries moderate their consumption, shifting to activities that use fewer raw materials, or they establish economic and political restrictions so that the most densely populated poor countries do not resort to means of consumption that devour natural resources. The first solution was inspired by the thesis of “alternative development” that emerged in the 1970s. However, trends in world consumption did not moderate; in fact, in the developed countries they intensified. In turn, the developing countries had to reduce their consumption, causing great frustration, not because of the introduction of another style of development but because of the recessive programs imposed by the IMF. The result was more negative than before because the poor countries had no alternative but to multiply exports of raw materials to pay off their external debt.

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Development Without Sustainability

There are more examples of development without sustainability. A typical case is laissez-faire capitalism, in which the economic order accepts no moral or political limits but imposes its own logic. In the case of politics the use of elected office to maximize profits is called corruption. The effects of development without sustainability are clearly seen in the majority of developing countries subject to adjustment programs with external financing. First, some price stability and moderate growth rates are achieved, which constitutes an important factor in countries that have gone through hyperinflation. But the financial sector is favored over the productive sector, external indebtedness soars, and distributive inequality is accentuated, resulting in a consequent concentration of economic activity. Last, decisionmaking at national level is transferred to international organizations or to a hegemonic power. Instruments of economic policy are reduced as the operative structure of the state is dismantled, and large numbers of public enterprises disappear, all under the constant monitoring by the IMF. With the political and moral orders subordinated to the logic of shortterm profitability, there is no limit on the unrestrained commercial exploitation of natural resources and public spaces. With no reflection on the meaning and purpose of economic activity and with the decisionmaking sovereignty of the national political order restricted, developing countries find their political capacity, which is the primary condition for sustainability, annulled. Sustainable Development

Perhaps there are situations in which development takes place with sustainability, as in the Nordic countries, but it is difficult to find examples in a world that is only just beginning to assimilate the concept. It is not necessary to elaborate a “utopia of sustainable development,” which would make for a good catechism but have no impact on reality. We prefer to remark that sustainable development is a methodology of analysis and action rather than a doctrine. The primacy of the moral, not as censuring of custom but as a reflection of good sense, permits the appearance of the political order, which provides order and purpose. Only at the level of political decisionmaking can actions be taken that favor development with sustainability in an economy marked by short-term interests. The economic/political/moral bases define the material structure of reality; but it is the moral/political/economic bases that link values and purpose.26 Naturally, it is not a question of imitating other triumphant ideologies, which claim to have the truth in all parts of the world at the same time.

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This would be an error and it is enormously arrogant in relation to civilizations that have existed for millennia, like the African, Indian, and Chinese, and that have a concept of time and space different from that of the industrialized West. For countries in the process of industrialization, the questions posed by sustainable development are these: What to do? How to act? Should development be limited in the periphery to guarantee the present style of consumption at the center? Is this a sustainable option? Is it not an illusion to think that the most industrialized countries will significantly reduce their contribution to pollution? Conclusions

Some conclusions can be drawn from these considerations. The first is that the problem is an enormous threat to human survival. Some of the consequences are now being felt, but others will only come to light in the future as a result of action taken now and in the recent past. Based on their size and area of influence, there are local environmental problems in drinking water, pollution, and waste disposal. And there are long-term global problems, such as climatic change, atmospheric pollution, depletion of the ozone layer, extinction of species, and desertification. The second conclusion is that our current problems cannot be solved in the framework of the dominant neoclassical thinking. Here we encounter the problem of the paradigms that explain reality. Such a view of things can be functional while its historical moment lasts; but when there is a substantial change in the problems the categories of analysis also have to change, as does the general framework of behavior. The result of applying the methodology of profitability to the problem of the right to life of future generations would be either comical or grotesque, if it were not so serious. Another conclusion about the relationship between sustainability and development shows that there are several ways to deal with this complex relationship, from one civilization to another, and from one state to another, and within the same country. We also find here differences in the way development is dealt with. But what is fundamental in this controversy is the political accentuation of the relationship. The term political has to be understood in all its meaning: from a bare-faced realpolitik that is the pattern of development in many countries or developed enterprises to the noble sense that puts political activity or decisionmaking at the service of a moral ideal. This is not abstract reasoning; it may be an illusion now, but it could become a reality in the future if conditions are generated for the welfare of humanity that do not include mortgaging the future. Any ideas presented from the economic

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viewpoint in the name of profitability should be confronted by this alternative view of the problem. The importance of the moral proposition lies in understanding that environmental degradation is not an economic matter but a political problem. To solve it, a hierarchy of values has to be reestablished: morality must set the objectives for political action, and the political sphere must prevent the economic sphere from standing in the way of sustainable development. The solution for the developing countries needs a clear view of the (moral) objectives and the (political) means of achieving sustainable development (in the economic sense). This exercise also reveals the logic of profit or power that underlies the debate on sustainability and development. Notes

1. Hans Jonas, Le principe responsabilité (Paris: Les Editions du Cerf, 1992), first edition in German in 1979, 190. 2. John Pezzey, “Economic Analysis of Sustainable Growth and Sustainable Development,” World Bank, Working Paper No. 15 (Washington, D.C.: 1989). 3. CEPAL, El desarrollo sustentable. Transformación productiva, equidad y medio ambiente (Santiago de Chile: 1991), 13, 29. 4. Institut Francais de Relations Internationales, Ramses 91, Le monde et son évolution, (Paris: Dunod, 1990), 316–319. 5. Agencia Europea para el Medio Ambiente, L’environnement dans l’Union Européenne 1995 (Luxembourg), 62. 6. Institut Français de Relations Internationales, Ramses 91, 324. 7. Ibid., 327. 8. Franck-Dominique Vivien, Economie et écologie (Paris: La Découverte, 1994), 58, 75. 9. Institut Français de Relations Internationales, Ramses 91, 345. 10. Fayçal Rachir, “Théorie économique et environnement,” Revue TiersMonde 130 (April-June 1992): 425. 11. René Passet, L’économique et le vivant (Paris: Payot, 1979), 59. 12. Juan Martínez Alier, “Economía y ecología: cuestiones fundamentales,” Pensamiento Iberoamericano 12 (July-December 1987) 45, 46. 13. Franck-Dominique Vivien, Economie et écologie, pags. 46, 103, 104. 14. Ibid. 15. Herman E. Daly, “Towards Some Operational Principles of Sustainable Development,” Ecological Economics 2 (1990): 1–6. 16. Juan Martínez Alier, “Economía y ecología: cuestiones fundamentales,” 41. 17. Roberto P. Guimaraes, The Ecopolitics of Development in the Third World (Boulder, Colo. and London: Lynne Rienner Publishers, 1991), 54–55. 18. See Helga Hoffmann, “Comercio y medio ambiente: ¿luz verde o luz roja?” Revista de la CEPAL 62 (August 1997): 138–143. 19. Quoted by Roberto P. Guimaraes, The Ecopolitics of Development, 53. 20. Ibid., 52, 54. 21. Ibid., 55. 22. André Comte-Sponville, Valeur et verité (Paris: Presses Universitaires de France, 1994), 212 ff.

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23. Carlos Astrada, La ética formal y los valores, (La Plata, Argentiina: Biblioteca Humanidades, 1938), 123–124. 24. CEPAL, El desarrollo sustentable, 55. 25. Marcel Mauss, Sociologie et anthropologie (Paris: Presses Universitaires de France, 1978). 26. André Comte-Sponville, Valeur et verité, 210 ff.

Appendix 1: First Meeting of Ministers, Caracas, Venezuela, 5–7 April 1972 1. The inaugural Ministerial Meeting of the Group of 24 was convened in Caracas on 5-7 April 1972 on the invitation of the Government of Venezuela. The Minister of Finance of Venezuela Pedro R. Tinoco Jr. was unanimously elected Chairman of the Meeting and the Minister of Finance of Ceylon W. N. Perera and the Governor of the Central Bank of Algeria M. S. Mostefai were also unanimously elected Vice-Chairmen. The purpose of the Meeting was to establish the position of the developing countries on the several fundamental issues concerning the reform of the international monetary system within the terms of reference specified in the declaration and working program of Lima. Mr. Pierre-Paul Schweitzer Managing Director of the IMF, and Mr. Manuel Perez-Guerrero, SecretaryGeneral of UNCTAD, also attended the Meeting. 2. The Ministerial Meeting was preceded by a meeting of the Deputies of the Intergovernmental Group in Caracas from 3-5 April under the Chairmanship of Carlos Rafael Silva of Venezuela with Lal Jayawardena of Ceylon as Vice-Chairman and S. B. Falegan of Nigeria as Rapporteur. Mr. Silva reported to the Ministers on the work of the Deputies. 3. The Intergovernmental Group of 24 was constituted as a result of a mandate given in Lima by the Group of 77 to their Chairman, to consult Member Governments on the establishment of an intergovernmental group on monetary issues. On the basis of these consultations the Group of 24 was accordingly constituted and held its preliminary meeting at the level of Deputies in Geneva in February 1972. 4. The Ministerial Group reviewed various substantive and procedural issues facing the international monetary system at the present time. It expressed its dissatisfaction that important decisions affecting the International Monetary System have been taken by a small number of developed countries to the exclusion and neglect of the interests of the rest of the 311

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international community, and that these decisions have adversely affected the economies of developing countries. 5. The Group, therefore considered that the most important task facing it at this moment is to provide for fundamental improvements in the decision-making process regarding international monetary issues. The Group agreed that the institution for decision-making on international monetary matters should be the International Monetary Fund. The members of the Intergovernmental Group unanimously decided to support the creation of a Committee of the Board of Governors of the IMF to advise the Board on issues related to the reform of the international monetary system. The Committee should be composed of 20 Governors, each selected from a constituency that appoints or elects an Executive Directory in a manner to be determined by each constituency. The representation of developing countries in this Committee should not be less than that on the present Board of Executive Directors. Such a Committee would represent a satisfactory compromise between the participation of the entire membership of the Fund in decision-making, and the need to limit numbers to levels that would promote effective consultation and negotiation. The Group of 24 at ministerial level will establish contact with the Governors representing developing countries in this Committee, once set up to consider arrangements for adequate coordination with the Group of 24. 6. The Ministerial Meeting also examined the issues connected with the next activation of SDRs from the standpoint of the Articles of Agreement of the IMF according to which the actuation of SDRs would depend on the long-term global needs for liquidity. The Group concluded that the international monetary experience of recent years is not sufficiently representative to constitute a reliable basis for predicting the future course of evolution of international liquidity. Furthermore, it considered that recent developments in the pattern of holdings of international liquidity, while tending to increase difficulties surrounding technical judgment in this area, should nevertheless be taken account of in determining the magnitude of liquidity creation. In the light of these considerations the Ministerial Meeting strongly supported the idea of a new activation of SDRs as from January 1, 1973. 7. The Group recognized that the magnitude of SDR creation should at all times be determined by the liquidity needs of the world economy. At the same time they were convinced that the SDR mechanism should be used to channel additional development finance to developing countries. Since the SDR system has enabled the developed countries to acquire additional international liquidity without the expenditure of real resources there is a strong case for transferring some portion of these savings to developing countries. The Group accordingly gave its fullest endorsement to the establishment of a link between SDRs and additional development finance. The Group urged that this principle be accepted by the international

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community at the forthcoming UNCTAD and be followed up by appropriate action by the International Monetary Fund and its members. 8. The Group expressed its dissatisfaction with the present system of determining Fund Quotas as this does not reflect the relative economic positions of Fund Members. It further recognized the necessity for modifying the present basis for the distribution of SDRs between developed and developing countries. 9. The Group agreed to meet again before the annual meeting of the IMF and IBRD, on the invitation of its chairman after previous consultations with member countries.

Appendix 2: Caracas Declaration II

The Ministers of the Intergovernmental Group of Twenty-Four (G-24) met in extraordinary session for their Fifty-Eighth Meeting in Caracas, Venezuela from February 7 to 9, 1998, and agreed to issue the following Declaration: The prime responsibility for development and poverty reduction in the developing world continues to rest with the peoples, institutions, and governments of the developing countries themselves. To this end, sound macroeconomic policies, transparency in the working of public institutions, and good governance are essential. Recent events in international financial markets demonstrate the profound implications of the intensifying integration and participation of developing countries into the global economy, and emphasize the need for global cooperation to preserve the stability of the international economic and financial system. The Asian crisis threatens to generate deflationary influences throughout the world. At the same time, the imminent introduction of a new currency—the euro—into the global economy creates more challenges for macroeconomic policy formulation associated with the functioning of the international financial system so far based on national currencies. These developments have shown that, without strengthened international cooperation (1) to improve the functioning of the global economy and (2) to reduce the potential costs and risks of globalization for its more vulnerable participants, the potential benefits of globalization are at stake. The Group of Twenty-Four agrees to: • promote an orderly and cautious approach to the liberalization of capital accounts under IMF auspices; • explore global arrangements for the purpose of securing an appropriate sharing of the cost of crisis resolution in postcrisis situations; • support efforts to strengthen and coordinate the work of agencies for financial market surveillance and supervision, and to pursue 315

Appendix 2

316 •

•

•

•

urgently discussions in respect of international arrangements for supervision and regulation of financial markets and institutions; endorse the initiative of the debt problem expressed in the Mauritius Mandate, adopted by the Commonwealth Finance Ministers last September, within the context of an appropriate burden-sharing arrangement, and to further the effort to seek permanent and creative solutions to the debt problems and development financing needs of the poorest countries; support an expanded role for the SDR in the international monetary system; welcome the principles expressed in the OECD Convention on Combating Bribery of Foreign Public Officials, recognizing that the fight against corruption must be carried on the basis of symmetry with regard to the responsibility of both developed and developing country governments; and to examine the Convention, along with other proposals, with a view to recommending them for consideration by governments; and, support national and international efforts to further develop and disseminate comprehensive and timely economic and financial information.

The Group of Twenty-Four sees an urgent need for a wide-ranging review by a Task Force comprising industrial and developing countries of the following issues:

• the capacities and modalities of the international monetary and development finance institutions to respond in a timely and effective manner to crises induced by large-scale capital movements; • the appropriateness of the conditions prescribed by these institutions to deal with such crises; • the equitable sharing of the costs of postcrisis financial stabilization between private creditors, borrowers, and governments; • the more effective surveillance of the policies of major industrialized countries affecting key international monetary and financial variables, including capital flows; the modalities for building domestic social safety nets as integral elements of stabilization and adjustment programs to protect the most vulnerable elements of the population of crisis affected countries; and, • the increased representation and participation of developing countries in the decisionmaking organs of the international community to properly reflect developing countries’ growing influence in the world economy, including through the revision of the bases for determining the voting power in international financial institutions.

The Contributors

Luis Enrique Berrizbeitia, former governor of OPEC and executive director of the International Monetary Fund, is executive vice president of the Andean Development Corporation, based in Venezuela. Ariel Buira, Mexico’s ambassador to Greece, served formerly as deputy governor of the Bank of Mexico and executive director of the International Monetary Fund. Alfredo Eric Calcagno, research director at Lanús National University, has also been on the faculty at both La Plata and Buenos Aires National Universities and at FLACSO. He has served as director of international trade and development at the UN Economic Comission for Latin America and the Caribbean (ECLAC) and as secretary general of the Argentine Federal Investment Council.

Eric Calcagno is executive director of the Youth Program of the Government of Argentina and director of the School of Entrepreneurial Economics, Lanús National University.

Francisco García Palacios has served in Venezuela as vice-minister of planning, vice-minister of development, and president of the National Securities Commision. He has also been governor of the OPEC Fund.

Javier Guzmán Calafell, from Mexico, is executive director of the International Monetary Fund.

Eduardo Mayobre is director of economic relations at SELA (Latin American Economic System). He formerly served as executive director of the International Monetary Fund and World Bank, and as Venezuela’s viceminister of finance and head of its Budget Office. 317

318

The Contributors

Aziz Ali Mohammed represents Pakistan in the G-24 deputies and has served formerly as head of the G-24 Liaison Office in Washington, D.C. and as alternate executive director in the International Monetary Fund.

Anwar Nasution is dean and professor of economics at the University of Indonesia. Yung Chul Park is professor of economics at Korea University.

Abdelkader Sid Ahmed, a native of Algeria, is professor at the University of Paris and researcher at the French Institute for Research and Development in Cooperation (ORSTOM).

Andrès Solimano, a Chilean native, is director of the Country Management Unit for Colombia, Ecuador and Venezuela at the World Bank. He formerly served as executive director of the Interamerican Development Bank. Francisco Suárez Dávila is Mexico’s ambassador to the OECD. He has served also as Mexico’s vice-minister of finance and as executive director of the International Monetary Fund.

Victor E. Tokman, from Argentina, is Regional Director for Latin America and the Caribbean, International Labor Office, and has served as director of the Regional Employment Program for Latin America and the Caribbean (PREALC).

Latin American Economic System (SELA) is an international organization that groups 28 Latin American and Caribbean countries and is devoted to the coordination of positions in international fora and cooperation in economic matters among its member countries.

Index

Africa, 56, 225 Aid programs and opening up the economy, 185–186 Air pollution, 293–294 Algeria, 27, 55, 60, 64 Analysis of multiple correspondences (AMC), 189–190 Andean Community, 198, 261, 262 Angola, 46 Ansah, Frimpong, 11 Arab Bank for Economic Development in Africa (BADEA), 56 Argentina: Asian economic crisis, 189; Brazil, trade with, 198; employment, 264–266; gold, 13; growth forecasts, 176, 177; inflation, 51; labor challenges of globalization, 268– 269; stock issuance, 59; wages, 272, 273 Aristotle, 298 Arriazu, Ricardo, 8 Arriola, Salvador, 14 Asian countries: Asian Free Trade Area, 261; Asian Pacific Economic Cooperation Group (APEC), 185, 198; Asia-Pacific Cooperation Forum (APEC), 261; Association of Southeast Asian Nations (ASEAN), 37; bank credits, syndicated, 59; East Asian Economic Council (EAEC), 261; stock issuance, 59 Asian economic crisis, 4; conclusions, 188–189; evaluating the crisis, elements for, 186; globalization, tensions and dilemmas of, 218; interpretations, varied, 184; miracles

into mirages, 22–23; solutions, appropriate political proposals and, 184–186; structural and temporary factors of the crisis, 182–184; trade, 178, 186–187; U.S. foreign policy, 187–188 Asian Miracle, The, 22 Asset markets, 218 Assiz, Jahangir, 205 Association of Southeast Asian Nations (ASEAN), 37 Asymmetric information, 155 Athena, Marc-Antoine, 34 Australia, 13

Bahrain, 46 Baker, James, 18 Balance-of-payment deficits/financing, 4, 55, 96–97, 219–220 Banks/banking: Algerian-Venezuelan development bank project, 55, 64; Arab Bank for Economic Development in Africa, 56; Asian countries, 59; Bank for International Reconstruction, 5; Bank for International Settlements (BIS), 95, 210, 229–230; Bank Indonesia, 99, 112, 114, 116, 119; credit, overextension of, 236; crises, 241; globalization, managing the negative side of, 221; government involvement, 111–112; Indonesia, 59, 99, 105–113, 122–123; Islamic Bank for Development, 56; Korea, 59, 151, 155; Latin America, 174, 175; liberalization of the banking

319

320

Index

industry, 109; management, streamlining internal, 257; multilateral development banks, 33, 38; restructuring, banking, 122–123; risk ratings, 174, 175; swindle banks, 112–113. See also International Bank For Reconstruction and Development (IBRD) Bedie, M. Konan, 12 Bemes, Thomas, 34 Bergsten, Fred, 11 Bernstein, E. M., 8 Best practices, access to ideas and international, 217 Bolivia, 264 Bond rates, 181–182 Borrowing, ceilings on public-sector, 119–121 Brady, Nicholas, 19, 227 Brazil: Argentina, trade with, 198; Asian economic crisis, 189; employment, 265; growth forecasts, 176, 177; labor challenges of globalization, 267–269; stock issuance, 59; wages, 272, 273 Bretton Woods Institutions (BWI), 3–5, 20, 28, 37–38, 216 Broad money (M2), 108

Camdessus, Michel, 22 CAMEL (capital adequacy, asset quality, management, earning, and liquidity) system, 111 Cameroon, 306 Canada, 13, 282 Capital adequacy ratio (CAR), 118 Capital assets, 59 Capital flows: advantages and risks of financial market integration, 228; Asian economic crisis, 186; background on, 223–224; conclusions, 245–246; consumption expenditure, financing, 104; controls on, 235–238, 256; domestic factors in emerging markets, 227; globalization, manifestation of, 196, 197; Indonesia, 60, 99, 124, 186, 255–256; industrial countries, stabilization in, 227–228; Korea, 144, 149, 156; lending boom, 105–108; macroeconomic consequences of, 231–233; market

integration in the 1990s, facts on financial, 223–225; newly industrializing economies, 101; private, 21, 251–260; renewed market access in the 1990s, factors behind, 226–228; resumption of capital inflows to emerging markets, 224–225; risks and costs of financial market integration, 228–231; structural changes in international financial markets, 226–227; volatility, financial, 220, 234–245, 251–260. See also Indonesia Capitalism, 303 Caribbean Community and Common Market (CARICOM), 261, 263. See also Latin America Ceilings on public-sector borrowing, 119–121 Central American Common Market, 261, 262 Chaebols, 146 Chile: air pollution, 294; employment, 264; growth forecasts, 176, 177; inflation, 51; labor challenges of globalization, 267–268; tariff cuts, 262; trade, 177, 178; wages, 272, 273 China, 59, 299 Chlorofluorocarbons (CFCs), 293–294 Climatic changes, 289, 293–294 Clinton, Bill, 188 Club of Rome, 82 Cold War, 290 Colombia, 198, 264–266 Commitment fee, 163 Competitiveness, 203–205, 273 Conditionality, 18 Consumption expenditure, capital flows financing, 104 Contagion effects, 155, 201, 230, 255 Controls on capital flows, 235–238, 256 Copper, 178 Costa Rica, 19, 264, 265 Creditworthiness, 230–231, 236 Crises and globalization, 3–4; historical background on, 21–24; institutional arrangements, strengthening, 239–242; institutional challenges of globalization, 219–220; managing the negative side of globalization,

221; policies for medium-sized open economies, risks and weak, 200; reacting to international emergencies, 258–259. See also Asian economic crisis; Indonesia; Korea; Mexico; Oil issues Cross-conditionality, 18 Currency depreciation, 99 Current-account deficits, 103–104, 116, 200

Data dissemination. See Information Debt: Baker Plan, 18; Brady Plan, 19, 227; decade of the debt crisis and dwindling role of G-24, 17–21; evolutionary phase of the monetary system, 10–11; IMF and International Bank For Reconstruction and Development, 19–21; Indonesia, 60, 105, 109; industrial countries, G-24 relations with, 34; Korea, 163; Latin America, 18, 97, 305; Mexico, 17, 225; monetary reform (1972-1982), 12; oil exporters, 60, 61; overhang, 64; privatization of, 51 Deflation, 10 Deforestation, 294–295 Dell, Sidney, 8, 14 Democratic Party, U.S., 188 Deregulation, 148–155, 203–204 Desertification, 294 Developed countries and environmental problems, 299 Developing countries, 31–32. See also individual subject headings Development Committee (Bretton Woods system), 3, 11–12 Development lending, 33, 38, 219–220. See also Sustainable development Disciplinary force for governments, globalization as a, 217 Discrimination, international mobility without, 275–278 Disequilibriums, macroeconomic, 10, 200, 233 Dooley, Michael, 236 DRI–Standard & Poor’s, 190 Dutch disease effect of the oil boom, 60, 101

East Asian Economic Council (EAEC), 261

Index

321

Ecologist economics, 296–300 Ecology, 289 Economic dimension of sustainability, 295–300 Economic integration, 261. See also Globalization; Labor challenges of globalization Economic stagnation/social inequality/environmental deterioration, 305 Economist, The, 213, 258 Edwards, Sebastian, 237 Egypt, 46, 60 Employment. See Labor challenges of globalization Energy resources, excessive extraction of, 292 Environmental pollution, 292, 293–295, 299 Eurocurrency market, 51, 93, 181, 225 European Free Trade Area (EFTA), 261 European Union (EU), 35, 198, 261 Evolutionary phase of the monetary system, 10–11 Exchange rates: appreciation, 237; capital flows, 232, 238, 253–254; flexible, 254; floating rate system, 8–9, 16, 99, 165; Group of 10 and 24, differences between, 16; Indonesia, 99, 101–103; Korea, 138–139, 149, 162, 165, 167; Latin America, 262, 263; volatility, financial, 220 Executive directors (EDs), 30, 31, 37–39

Fadil, Abdel, 60 Falegan, M., 7 Fekrat, Ali, 60 Feldstein, Martin, 23 Fernandez Hurtado, Ernesto, 11 Financing, external, 172, 178–182. See also Capital flows Flight to quality phenomenon, 172 Floating exchange rate system, 8–9, 16, 99, 165 Foreign direct investment (FDI), 106, 225 France, 13, 154 Frankel, Jeffrey, 238 Future of the Group of 24: approaches for dealing with future issues, 39;

322

Index

changing content of G-24 work, 28–29; contacts outside the governmental universe, 38; dichotomy between industrial and developing countries, 35–36; relations with other groupings, 30–35; representativeness of the G-24, 36–38; unresolved issues, 29–30 Gabon, 45 General Agreement on Tariffs and Trade (GATT), 198, 261, 262, 282, 283 Germany, West, 84 G-24 (Group of 24), 3. See also Future of the Group of 24; Historical background on G-24; individual subject headings Globalization: avoiding or withdrawing from, 195–196; capital movements, 197; complex and multifaceted phenomenon, 195; conclusions, 213, 222; and domestic policies, 199–205; elements of, 196–199; historical background, 215–216; institutional challenges, 219–221; Latin America, 262–264; liberalization, financial, 202–203; macroeconomic policies, 199–201; multilateral agencies, 211–213; opportunities of, 217–218; policy complementaries, 204–205; regional and national institutions, 221; state, the role of the, 205–208, 221; supervision/regulation of international players, 210–211; surveillance of macroeconomic policies, regional, 208–210; tensions and dilemmas of, 218–219; trade, 196, 197–198, 201–202; World War I, 195. See also Crises and globalization; Labor challenges of globalization “Globalization of International Capital and Financial Markets,” 34 Godman and Morgan, 189 Gold, 10, 13, 90–91 “Good Governance,” 34 Governmental models, 38 Government involvement in banks/ banking, 111–112 Group of 5, 4 Group of 7, 4, 10, 35

Group of 9, 6, 31, 37–39 Group of 10, 4–6, 15–16, 20 Group of 15, 37 Group of 24, 3. See also individual subject headings Group of 77, 6, 7, 15, 30, 56 Growth, economic, 4–6, 176–177, 217 Guatemala, 306 Guerrero, Perez, 7 Gulf Cooperation Council, 62 Gulf economies, 45–46. See also Oil issues

Henning, C. Randall, 36 Herd behavior and foreign investors/financial institutions, 155, 201, 230, 255 Higgins, Bryon, 236 HIPC (Heavily Indebted Poor Countries), 212 Historical background on G-24, 3; 1946-1970, 4–6; 1971- 1972, 6–8; 1972-1982, 8–16; 1982-1992, 17–21; 1993- 1997, 21–24; first meeting, 27–28 Human capital, improving, 199, 207–208

IBRA, 122–123 IMF. See International Monetary Fund Import substitution industrializing (ISI), 103 Income/wages, 219, 267, 269–270, 272–273, 305 India, 59, 299 Indonesia: aid programs and opening up the economy, 185–186; banks/banking, 59, 99, 105–113, 122–123; borrowing, ceilings on public-sector, 119–121; capital flows, 60, 99, 186, 255–256; chronology of policy response to speculative attacks, 126–130; conclusions, 123–126; currentaccount deficit, 103–104; debt, 60, 105, 109; exchange rates, 99, 101–103; fiscal policy, 121–122; globalization, tensions and dilemmas of, 218; Group of 15, 37; imbalances leading to economic crisis, 200; interest rates, 99; liquidity, direct control, 118–119; macroeconomic

policy, 100–105, 113–123; spread levels, 181–182; stock issuance, 59; volatile capital movements, 64 Industrial countries: G-24 relations with, 33–36; inequalities between developing and, 4, 219; stabilization in, 227–228 Inequality between industrial and developing countries, 4, 219 Inflation, 10, 51, 216, 225, 227 Information: asymmetric, 155, 230; to markets, providing, 201; technologies, 226; transparency in the dissemination of economic and financial data, 257–258 Infrastructure, 204 Institutional challenges of globalization, 219–221 Integration agreements, multi-country, 261–263. See also individual agreements Interest rates, 51, 99, 101, 139–140, 220, 233 Intergovernmental Group, 33 Interim Committee (Bretton Woods system), 3 International Bank For Reconstruction and Development (IBRD), 5; Asian economic crisis, 184; Baker Plan and the debt crisis, 18; controls, capital, 256; crisis, international monetary, 23–24; debt crisis (1982-1992), 19–21; Development Committee, 11–12; executive directors, 30; HIPC (Heavily Indebted Poor Countries), 212; industrial countries, G-24 relations with, 34; OPEC countries, projections on surpluses of, 82 International financial institutions (IFIs), 219, 220 International Fund for Agricultural Development, 55 International Labour Organization (ILO), 282–284 International Monetary Fund (IMF): Asian economic crisis, 184, 185, 188; Baker Plan and the debt crisis, 18; balance of payments with aid to projects, combining support to the, 55; controls, capital, 256; cooperation with other agencies, 55–56; crisis, international monetary,

Index

323

23; data dissemination, 201; debt crisis (1982-1992), 19–21; emergence of, 216; evolutionary phase of the monetary system, 10–11; executive directors, 30; gold, 10, 13, 90–91; Group of 10 and 24, differences between, 16; historical background on G- 24, 6, 7, 13; Indonesia, 114–115, 122; industrial countries, G-24 relations with, 34; Korea, 137, 159–162, 167; Mexico, 239–240; monetary reform (19721982), 11–16; moral hazard in domestic/international financial systems, 156–157; oil issues, 12–13, 55, 62, 83, 93–94, 96; quotas, 12, 27, 28; reserve positions for developing countries, 3; resources available to, clearly defining the, 220; special drawing rights, 10; strengthening the, 212; surveillance of macroeconomic policies, regional, 209–210; volatility, financial, 234, 239–245 International monetary system (IMS), 27. See also Historical background on G-24 Investment(s): Asian economic crisis, 181, 186; controls, capital, 237; exchange rates, 101; foreign direct, 106, 225; Korea, 142–148; multilateral development organizations, 96; overinvestment in the nontraded and the manufacturing industry, 123–124; portfolio, 156, 181 Iran, 12 Ireland, 154 Islamic Bank for Development, 56 Italy, 10

Jakarta Stock Exchange, 299 Japan, 84, 185, 187 Jayawardena, Lal, 7 Jonas, Hans, 290–291

Kafka, Alexandre, 11 Kenya, 13 Keynes, John M., 4 Khayyam, Omar, 291 Kletzer, Kenneth, 237 Korea: aid programs and opening up the economy, 185; banks/banking,

324

Index

59, 151, 155; buildup to the crisis, 141–145; capital flows, 186, 255–256; chaebols, 146; crisis, overview of financial, 137; deregulation with inadequate supervision, 148–155; exchange rates, 138–139, 149, 162, 165, 167; imbalances leading to economic crisis, 200; interest rates, 139–140; investment boom, financial opening and, 142–148; liberalization in emerging market economies, financial, 163–166; overshooting and moral hazard, 155–158; prevention and better management of financial crises, 158–163; reflections on the crisis, 166–168; reform of the international financial system, lessons and, 155–166; spread levels, 181; stocks, 59, 140–141; transparency in the dissemination of economic and financial data, 258; wages, 272, 273 Kuwait, 12, 45, 47, 56, 59, 62 Kwakiutl societies, 306

Labor challenges of globalization, 218, 261; conclusions, 285–286; cost of labor/productivity and competitiveness, 272–275; crossborder emigration, 199; discrimination, international mobility without, 275–278; employment trends in the 1990s, 264–266; inequalities between skilled and unskilled labor, 199; instability, employability in a context of occupational, 278–280; trade and the fundamental rights of workers, 280–284; wage and employment policies in more interrelated economies, 269–272; wages/productivity/employment, effects of integration on, 266–269 Latin America: air pollution, 294; Asian crisis affecting, 188–189; capital flows, 225; debt, 18, 97; economic stagnation/social inequality/environmental deterioration, 305; exchange rates, 262, 263; financing, questions surrounding external, 178–182;

globalization, 262–264; inflation, 51; law, guaranteeing the rule of, 207; MERCOSUR, 198, 261, 263, 277–278, 280–281; resources, depletion of natural, 305; resource transfers, capital markets and, 11; risk ratings, 172–177; spread levels, 181; stock issuance, 59; trade, 171–172, 177–178. See also Labor challenges of globalization; individual countries Latin American Integration Association (LAIA), 261 Law, guaranteeing the rule of, 207 Lending boom, surges in capital inflows and the, 105–108 Levy, Walter, 52 Liberalization, economic, 109, 163–166, 201–203, 237 Libya, 45 Liquidity: bandwagon effects, 230; debt crisis (1982-1992), 17–18; direct control, 118–119; floating rate system, 16; globalization, managing the negative side of, 221; Indonesia, 99, 118–119; maturity mismatches, 109; oil issues, 89–91 Lissakers, Karen, 34 Loans, problem, 109–111

Macroeconomic policies: capital flows, 231–233; consultation and coordination, 220; disequilibriums, 10, 200, 233; globalization, 199–201; Indonesia, 100–105, 113–123; instability/uncertainty, reducing, 271; 1920s, 216; private capital flows, volatility of, 253–260; surveillance of, regional, 208–210 Malaysia: banks/banking, 59; capital flows, 186; Group of 15, 37; imbalances leading to economic crisis, 200; Korean securities firms, 154; oil issues, 46 Malpass, David, 241, 242 Managed floating system, 165 Marco del Pont, Guillermo, 7 Market integration. See Capital flows Martínez, Juan, 298 Massad, Carlos, 8 Maturity mismatches, 108–109 McNamara, Robert, 12

MERCOSUR, 198, 261, 263, 277–278, 280–281 Mexico, 46; Asian economic crisis, 189; Bank for International Reconstruction, 5; Brady Plan, 19; chairmanship of G-24, 14; debt, 4, 17, 22, 225; employment, 265; globalization, tensions and dilemmas of, 218; gold, 13; growth forecasts, 176; imbalances leading to economic crisis, 200, 201; International Monetary Fund, 13, 239–240; labor challenges of globalization, 268–269; Organization for Economic Cooperation and Development, 32, 35; spread levels, 182; stock issuance, 59; transparency in the dissemination of economic and financial data, 258; volatile capital movements, 64; wages, 272, 273 Middle East, 225 Migrant workers, 275–278 Mistrust regarding the emerging markets, 172 Mobility, increasing capital, 253 Monetary base, the identity of, 116 Monetary reform (1972-1982), 11–16 Monetary system, international, 27. See also Historical background on G-24 Moral aspect of sustainability, 302–304 Moral hazard in domestic/international financial systems, 155–158, 163, 244–245 Mostefai, M. S., 7 Multilateral agencies, 96, 198, 211–213, 261. See also agreements under Trade Multilateral development banks (MDBs), 33, 38 Mundell, Robert A., 8

Neoclassical economics, 295–296 Neoliberal thinking, 4 Nigeria, 55, 60 Nongovernmental organizations (NGOs), 31, 33, 38 North American Free Trade Agreement (NAFTA), 35, 198, 261, 263, 277, 280–282

Oil issues: aid to other developing countries, oil exporter, 53–59; capital

Index

325

flows, 224; crisis of 1979, 10; debt, 60, 61; development, oil revenues and, 59–70; Dutch disease effect of the oil boom, 60, 101; final considerations, 97–98; globalization, tensions and dilemmas of, 218; imbalances, financing of the external, 85–88; international financial market, oil revenues recycling in the, 47–53; International Monetary Fund, 12–13, 55, 62, 83, 93–94, 96; Latin America, 178; liquidity, international, 89–91; petrodollar emergence, the oil boom and the, 45–47; prices and international transactions, 81–85; price shocks, 223–224; recycling the petrodollars, 91–97; vulnerability of oil economies, 59–64 Oligopolistic practices, regulation of international, 211 Oman, 46, 59 Organization for Economic Cooperation and Development (OECD), 32, 35, 52, 82 Organization of African Unity (OAU), 37 Organization of Petroleum Exporting Countries (OPEC), 45–46, 55, 87–88. See also Oil issues Ostry, Jonathan, 237 Overshooting model, 237 Ozone layer, depletion of the, 289, 293–294

Panama, 265 Parliamentary democracy, Westminister model of, 38 Peru: employment, 264–266; growth forecasts, 176; labor challenges of globalization, 267–268; tariff cuts, 262; trade, 177; wages, 272, 273 Petrodollar phenomenon, 45–46. See also Oil issues Philippines, 186, 200 Phillips, Alfredo, 8, 11, 14 Policy complementaries, 204–205. See also Macroeconomic policies Politics and sustainable development, 300–302 Politics (Aristotle), 298

326

Index

Pollution, environmental, 292, 293–295, 299 Portfolio investments, 156, 181 Power industry, 203 Price-based controls, 238 Private capital flows, 21, 251–260 Privatization, 203, 206, 230, 275–276 Productivity and labor costs, 273–274 PT Steady Safe, 108

Qualitative/quantitative variables and analysis of multiple correspondences, 190 Quantity-based controls, 238 Quotas and the IMF, 12, 27, 28

Reagan, Ronald, 185 Recycling the petrodollars, 91–97 Reforms, second-generation, 207 Regional institutions, 221 “Regulation of the International Financial System,” 34 Regulation/supervision of globalized economy, 210–211 Republican Party, U.S., 188 Rescue packages, 219 Reserve assets, 234–235 Reserve requirements for discouraging speculative capital movements, 237–238, 255 Resources, depletion of natural, 305 Resource transfers among developing countries, 11, 56 Ricardian equivalence issue, 104 Rights of workers, 280–284 Risk ratings, 172–177 Rose, Andrew, 238 Russia, 220

Sachs, Jeffrey, 23, 242 Saudi Arabia, 12, 48, 59 SBIs (Bank Indonesia Certificates), 117–118 Schmidt, Helmut, 13 Schweitzer, M., 7 Second-generation reforms, 207 Securities firms, Korean, 154 Securities Supervisory Board, 154 Securitization, 226 Securitized capital, 156 Services, public, 204

Sid Ahmed, Abdelkader, 60 Silva, Carlos, 7 Social charters, 280–281 Social effects of globalization, 218–219 Soil quality, 294 Soros, George, 230–231 South Africa, 13, 37 Southern Common Market, 263 South-South cooperation, 56 Soviet Union, the former, 196, 205 Spahn tax, 121 Special drawing rights (SDRs): historical background on G- 24, 8, 27–28; industrial countries, G-24 relations with, 34; Jamaica Accords of 1976, 10, 14–15; limited distribution of, 5; monetary reform (1972-1982), 12; reserves, raising global, 89–90 Special Working Group (SWG), 28– 29 Speculation, limiting private-sector, 237–238, 255 Spread levels, 181–182 Sri Lanka, 27 State role in globalization, 205–208, 221 Steady Safe, 108 Sterilization operations, 115–118, 231, 254–258 Stiglitz, Joseph, 185 Stock markets, 59, 140–141, 171, 299 Suárez, Eduardo, 4 Summers, Lawrence, 258 Supervision/regulation of globalized economy, 210–211 Supply-side efficiency, 203 Surveillance of macroeconomic policies, regional, 208–210 Sussman, Oren, 237 Sustainable development, 289; analytical framework, an exacting, 290–291; conclusions, 308–309; definition of, 291–292; economic dimension of sustainability, 295–300; moral aspect, 302–304; political problem, 300–302; scenarios for dealing with, four, 305–308; threats to, 292–295 Swindle banks, 112–113 Syria, 46

Taiwan, 59 Taxes: and capital shifting, 120–121; on short-term inflows, 237; tariff cuts, 262 Technical Group (TG), 29 Thailand: aid programs and opening up the economy, 185; capital flows, 186; imbalances leading to economic crisis, 200; spread levels, 181; stock issuance, 59 Tinoco, Pedro, 7 Tito, Marshal, 14 Tobago, 46 Tobin tax, 120–121 Tolba, Mostafa K., 302 Trade: agreements, 35, 198, 261–263, 277–278, 280–282; Asian economic crisis, 171–172, 186–187; globalization, manifestation of, 196, 197–198; labor challenges of globalization, 280–284; Latin America, 171–172, 177–178; liberalization, 201–202; U.S. trade policy, 185 Transition economies, 21 Transnationalization of firms, 271, 276 Transparency in the dissemination of economic and financial data, 257–258 Treaties/conventions/accords: Arusha Declaration, 15; Basel Capital Accord of 1998, 220; Basle Convention of 1989, 300; Caracas II, 27, 56; Convention on Biological Diversity, 300; Convention on International Trade in Endangered Species (CITES), 300; European Community Charter, 280; Jamaica Accords of 1976, 8, 10, 14–15; Kyoto Conference, 62–63, 301; Lima meeting of 1971, 33; Louvre Accord of 1987, 16; Manila Declaration of 1997, 33; Montreal Protocol on Ozone- Depleting Substances in 1987, 301; Multilateral Agreement on Social Security, 278; Plaza Hotel Accords of 1985, 185; Smithsonian Agreement, 6; Social Summit in Copenhagen in 1995, 284; Tehran Agreement of 1970, 45; UN

Index

327

Conference on the Environment and Development in 1992, 300; UN Framework Convention on Climatic Change, 300; Vienna Convention on Protection of the Ozone Layer in 1985, 301; Williamsburg, Virginia Summit, 15; WTO Summit in 1996, 284 Trinidad, 46 Tunisia, 46

United Arab Emirates, 45, 47, 59 United Kingdom, 10, 12, 84 United Nations: Conference on the Environment and Development in 1992, 300; Conference on Trade and Development (UNCTAD I), 5–6, 13, 32; Convention on Climatic Change, 62; Development Program, 33; Framework Convention on Climatic Change, 300; Group of 24 and, relations between, 30, 32–33; Program for UN Development Agencies (AG Fund), 56 Urbanization, 295 U.S. constitutional model of government, 38 U.S. foreign policy and the Asian economic crisis, 187–188

van Wijnbergen, Sweder, 237 Venezuela: Algerian-Venezuelan development bank project, 55, 64; chairmanship of G-24, 24; Colombia, trade with, 198; creditor nation, 12; debt, 60; employment, 265; G- 24, first meeting of the, 27; growth forecasts, 176, 177; multilateral development agencies, 96; stock issuance, 59; tariff cuts, 262; Venezuelan Investment Fund, 56 Volatility, financial: controls on capital flows, 235–238; counteracting, three lines of action for, 234; exchange and interest rates, 220; Indonesia, 64; institutional arrangements, strengthening, 239–242; lender of last resort, 242–244; moral hazard, 244–245; private capital flows, 251–260

328

Index

Wages, 219, 267, 269–270, 272–273, 305. See also Labor challenges of globalization Wardhana, Ali, 11 Water pollution, 294 Weatherstone, D., 11 Wescott, Robert, 205 Westminister model of parliamentary democracy, 38 White, Harry, 4

Witteven, Johannes, 96 Worker’s rights, 280–284. See also Labor challenges of globalization World Bank, 5. See also International Bank For Reconstruction and Development (IBRD) World Trade Organization (WTO), 28, 185, 198, 261, 262, 282 World War I and globalization, 195 Yugoslavia, 14, 30

About the Book

Appearing some twenty-five years after the inaugural meeting of the Group of 24, this book relates the efforts made by developing countries in the arena of international monetary issues. A reflection on a quartercentury of both frustration and modest achievement, it deals as well with matters central to the future of global economic relations. The authors, distinguished scholars from developing countries, all have had direct practical experience in international affairs and policymaking. They provide rare insight regarding the continuing efforts of the developing countries to express, coordinate, and advance their positions and interests. Eduardo Mayobre is director of economic relations at SELA (Latin America Economic System).

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