Summary:JAMES BARTH: In November 1997, Michel Camdessus, the IMF's managing director, stated: "The Asian crisis resulted from overvalued real estate markets, weak and overextended banking sectors, poor prudential supervision, and substantial short-term borrowing in foreign currencies." Robert Rubin, the U.S. Treasury secretary, stated in January 1998 that "The Asian crisis demonstrates that markets cannot be trusted to correct their own excesses." Finally, Joe Stiglitz, the chief economist at the World Bank, in December 1997 stated that "The buildup of short-term unhedged debt left East Asia's economies vulnerable to a sudden collapse of confidence. As a result, capital outflow, and with it depreciating currencies and falling asset prices, exacerbated the strains and private sector balance sheets, and thus proved self-fulfilling. This should be addressed by establishing an effective regulatory system improving corporate governance and enhancing transparency more broadly."
GLENN YAGO: Gary Becker stated that "obtrusive regulations and excessive government control over the financial sector were the weakest links in the economic superstructure of Indonesia, Malaysia, Thailand, and South Korea. Their governments regularly gave subsidies and other assistance to favorite companies and bailed out those that got into financial difficulties. The IMF and other international organizations are distorting incentives further." And Bob Kuttner wrote in The American Prospect that "The IMF was designed in 1944 expressly to prevent the currency deflations and financial panics that deepened the Great Depression. But the IMF is now the premier instrument of deflation as well as the most powerful unaccountable institution in the world."
What are the issues as seen from perspectives of other leaders in the world? In an extremely impressive inaugural address, the new president of Korea, Kim Dae Jung, noted that "political, economic and financial leaders of [his] country were tainted by a collusive link between politics and business and because of government-directed banking practices, and because large business groups set up a large number of uncompetitive subsidiaries." George Shultz, Bill Simon, and Walter Wriston all commented similarly that "as is typical when the IMF intervenes, the government and lenders were rescued, but not the people. The IMF is inefficient, unnecessary and obsolete," to state the most extreme criticism of the IMF.
JAMES BARTH: Henry Kaufman has stated that, "The IMF needs to be reorganized." Henry Kissinger has stated that "the typical IMF rescue program is in urgent need of re-evaluation." And Jeffrey Sachs, a fairly prominent and outspoken critic of certain aspects of IMF programs, has stated that "Asia has been hit by a financial panic that vastly exaggerates the fundamental ills of the Asian economies. The IMF has not stopped the panic, and arguably has added to it, both by its rhetoric, which underplays the role of panic and overplays the weaknesses in Asia, and by its draconian economic policy conditions."
One solution individuals have proposed with respect to dealing with certain aspects of the problems is deposit insurance. Yet some economists at the World Bank have recently performed studies indicating that deposit insurance makes banking crises more likely and severe. The New York Times reported in January 1998 that a confidential report by the International Monetary Fund on Indonesia's economic crisis acknowledges that an important statement of the IMF rescue strategy backfired, causing a bank panic that helped set off financial market declines in much of Asia.
GLENN YAGO: Should the IMF intervene when there is a currency crisis, or a crisis of confidence?
DAN BRUMBAUGH: My goal is to try to explain what caused the difficulties the banks are facing in East Asia and perhaps suggest the best path to resolution.
The 19 nonoverlapping countries of the European Union and the G-10 account for only 14 percent of the world's population, or 770 million people. But those countries account for 76 percent of world GDP (gross domestic product). The remaining 180 countries in the world account for 86 percent of the world's population, 4.7 billion people, and they account for only 26 percent of world GDP.
Similar disparities exist for world banking assets, world equity capitalization, and international debt securities. These disparities are the key to understanding what the overall goal should be in resolving these banking crises, namely, to help make certain that developing and emerging countries are able to access the capital markets from the developed world, where the world's wealth is lodged. For a long time, however, the general approach taken by the transnational agencies in banking crises has been clear. The Basle Committee of Bank Supervisors, the Bank for International Settlements, the IMF, and the World Bank all have been moving toward international bank regulatory protocols. These protocols are based, in general, on the prevailing view that international banking crises are caused by or reflect lax examination, supervision, and regulation and by inappropriate closure policies and capital level regulation.
The regulatory prescription that generally follows is to establish international capital requirements and closure rules as well as internationally approved bank regulations for allowable activities, examination, supervision, and location, among other things. This prescription also is based on the notion of imposing a deposit insurance system similar to the one we have in the United States.
This interpretation presents only a small part, and a distorted part, of the overall picture. Rather, the most important issue that needs to be addressed is the widespread and inappropriate intrusion of the region's governments in the banking and financial markets. The results are financial decisions based on nothing resembling a market analysis of risk and return. The remedies that should be adopted are substantially different than those that the transnational agencies are pursuing.
It is true that the IMF has supported "transparency" and that, on an ad hoc basis in this crisis, it has supported private ownership of banks, limitation of state ownership of banks, and the like. However, since 1989 and the original Basle accord, which began the transnational agencies' involvement in these sorts of things, these policies have not been anywhere near the central components of what they have proposed.
It is important to get an understanding of just how prevalent state-owned banks are. As a percentage of total assets in emerging East Asian countries relatively recently, state-owned banks have accounted for over 20 percent of bank assets. Approximately 43 percent of bank assets in Indonesia are in state-owned banks. Though that's substantial, it's down from about 54 percent in 1991. There's been a corresponding increase in the assets of private banks. But the assets in joint-venture banks and foreign banks have only been 10 percent of assets through this period.
In terms of the efficiency of state banks relative to private banks, nonperforming loans among state banks have been substantially higher than private banks. Very recently, for example, nonperforming loans in state banks were 15 percent of total assets, whereas in private banks they are only 5 percent of assets.
The return on average assets for foreign banks is substantially greater than for state banks. Even in countries where state banks are not prevalent (for example in Korea, where there are only two state-owned banks, neither one of which is in the top ten) one can still see substantial state intrusion in the financial markets. Political influence on lending decisions appears to continue. A World Bank footnote says commercial banks still had $4.5 trillion in loans on their books at the end of 1996, 56 percent of which were nonperforming. This is the outcome when state-owned banks are not predominant but the state directs lending to selected enterprises. But depending on the degree of state influence in this fashion, if lending decisions are directed by governments to private banks, the notion of inadequate supervision, or regulations, simply cannot apply.
It's important to evaluate the composition of the financial markets in terms of the percentage of GDP, for example, that are allocated to banks as against bond markets and equity capitalization. With the exception of Hong Kong's, Malaysia's, and Singapore's equity markets, the banking sectors in all of the other countries are very large relative to the bond and equity markets. This can be important because for a given level of state ownership of banks, if the banking sector is large relative to the other sectors, the other sectors can be dominated by the banking sector, which has tremendous government involvement. In addition, commercial firms will have much less access to nonbank, nonstate bank sources of funds. In addition, the financial market is going to be subject to greater instability if one sector dominates another. And if that one sector falters, the effects on development and the economy are going to be greater.
Once again, the example of Indonesia is instructive. The Indonesian banking sector is substantially greater than either the bond or equity sector. In contrast, the U.S. banking sector is dominated by the equity markets and bond markets. In Indonesia the bond market is only approximately 5.8 percent of GDP. In Indonesia, Thailand, and India, the percentage of state enterprise bonds, which are state bonds for commercial purposes, exceeds 60 percent of the corporate bond market plus state enterprise bonds. So there is dramatic involvement in the government in these countries throughout the financial markets.
It is helpful to look at the developing countries for some answers, because since 1980, three-quarters of all IMF countries have faced some sort of banking crisis. Indeed, at the moment, 58 countries in the IMF in 1997 were receiving some kind of state assistance, either to improve their monetary policies or bank practices. But in developed countries that have all the attributes of a regulatory system of the IMF, there have been dramatic difficulties in recent years. Spain, Canada, Denmark, the United States, Germany, France, Italy, Finland, Switzerland, and Japan all have had severe banking crises in the last 20 years.
Perhaps the best window through which to see the implications of this is the savings and loan crisis that occurred in the United States in the 1980s and 1990s. The savings and loans had every regulatory apparatus that the IMF wants to apply to international banks, including, among other things, prompt corrective action mechanisms. The savings and loans were the most highly regulated privately owned firms in the world at the time of the crises in the 1980s. What happened? Simultaneously, with all this regulation, examination, and supervision, the savings and loans were required to make fixed-rate, long-term mortgages. They were actually prohibited by law to make variable-rate loans or to hedge their interest risks in the futures and options market. Then the yield curve inverted, and as a result the institutions were entirely insolvent by 1981. At the same time, the deposit insurance reserves of the savings and loan insurance corporation were approximately $100 billion short of what was going to be required in order to resolve the total number of institutions that were underwater.
With full knowledge of the situation, Congress jettisoned all the prompt corrective action mechanisms, lowered capital requirements, and allowed the Federal Home Loan Bank Board to keep insolvent institutions open and operating. As economists, we would say that the problems that are thought to create bank instability, problems with information asymmetry and moral hazard, were swamped by problems created by the regulatory mechanisms that we had. That created even greater moral hazard, principal-agent problems, and adverse selection, which completely swamped the savings and loans.
If governments can restrain themselves from intruding into the financial markets through state ownership of banks and from intruding into bond markets and other markets, the markets could actually provide solutions today, given the availability of technology to gather, evaluate, and monitor relevant information. Markets can work if they are allowed to do so.
PAUL HOLDEN: I could start by paraphrasing Shakespeare and say, "I come to bury the IMF not to praise it." But the context is a little different, and I don't mean to say exactly that.
In 1900, Asia contributed about one-third of world GDP. After the Asian miracle it is starting to approach that level again. So, historical context is often important when looking at trends that last 20 years or less.
I am going to dwell on two things. One is how the institutional underpinnings of financial markets relate to market structure and influence behavior. The second is to relate them to circumstances under which the IMF can influence these factors, under which I think the IMF can help, and under which it does the opposite.
But first, consider the process of economic development. Essentially it is a large increase in the number of transactions. It is closely associated with industrialization and commercialization. It involves business relationships opening up to transactions that are geographically more distant, and with people whom the contractors do not necessarily know very well.
In other words, transactions become increasingly impersonal. As a result, the amount of risks as economic development proceeds increases, because development requires increasing specialization and division of labor. It requires greater investment and initiation of transactions and investments over a long period, the fruits of which come only after a period of time.
So, as development occurs, institutions, which underpin that development, need to evolve. A lot of them are associated with the provision of public goods for governments.
We have heard of the damage governments can do by intervening where perhaps they don't have a comparative advantage intervening. But there are other areas where they have a distinct comparative advantage, for example, in implementing systems like law and order. In development terms, they should be associated with institutions that allow stable contracting, help define secure property rights, and provide a basis for managing the risk associated with development. It is not only government that has a monopoly on risk-bearing institutions, but government has an advantage in some areas. And I believe that however libertarian one wants to be, government certainly has a role to play.
For those of us lucky enough to live in industrialized countries, particularly in the United States, we take many of these institutions for granted. In reality, many of them either do not exist in the developing world or are extremely underdeveloped. First, let's look at property rights.
In Latin America there are few countries in which property is clearly defined. Even in Chile, the number of property-titled dwellings is very low. This means that the financing of mortgages simply does not work. It is not available to the vast majority of people in Latin America and in many other developing countries. Banks don't lend because the institutional underpinnings simply do not exist. Repossession of property in the event of default is banned constitutionally in many countries. So the basics, in terms of financial markets here, don't exist there.
The situation is even worse when it comes to lending against movable property. Movable property loans are almost unknown in most of Latin America. They are not very well developed in most other parts of the developing world. As a result, the financial structure of markets, as Dan Brumbaugh pointed out, is dominated by banks.
This is not necessarily a bad thing, because in the initial phases of development, the banking system is probably the most efficient way of channeling funds from savers to investors. But it also means that access to the banking system is available to a very small number of people, or a relatively small number of people. This is happening not only in Latin America but in many countries in East Asia.
Furthermore, bankruptcy laws, which exist because bankruptcy is a way of transferring assets from an inefficient use to an efficient use, are also problematic. In many countries it is impossible to close down businesses in the event of default. Indonesia is a case in point. There was an article in The Economist recently about a Hong Kong bank that had made a large loan to a company in Indonesia. The Indonesian company defaulted. The Hong Kong bank had to close down. The Indonesian company is still operating, business as usual.
This example is a perfect illustration of my point that bankruptcy laws don't work. It also shows that it is almost inconceivable that the Hong Kong financial institution did not know that it was impossible to put its client out of business in the event of default. Similar factors apply in contracting systems; the former Soviet territories are a perfect example. Many businesspeople have gone there attempting to enter into contractual relationships. They find that contracts are simply not enforceable. Several people have lost large amounts of money because of this. It has one particularly unfortunate effect in many developing countries: It perpetuates the concentration of wealth to a relatively small number of people. Latin America has one of the most unequal income distributions of any area in the world. Indonesia is a similar case in point. This creates or adds political risks to the economic risks, because reforms benefit a relatively small portion of the population, which makes the political dynamic very unstable. And if one looks at the extent of reforms in Latin America over the past 10 years, this is only one, or it's only the most recent, of at least four waves of reform, all of which were previously reversed.
How does the IMF feature in this institutional soup? Not very well. The IMF does some things quite well. When there are serious macroeconomic imbalances in the form of budget imbalances, high inflation, and exchange rates that are not reflected by the underlying fundamentals, it does quite well. When I was at the IMF I was involved in several arrangements to "bail out" governments, and those governments would rather have taken poison than do what we said. This is not something that's politically palatable. They find it humiliating and I don't believe that it is a factor in governments' behavior. The IMF has been a useful policy scapegoat because when governments have had to make difficult decisions in the macroeconomic area, they have been able to use the IMF as the reason for having to do it and have been able to say things are out of their hands. So from that point of view, I think the IMF was quite good.
However, in the current situation in East Asia, one has to question whether the IMF even has the expertise to deal with these issues. I have great admiration for IMF staff. It is very highly trained, but it subscribes to a particular macroeconomic model. And the events there, I believe, are outside the ambit of that model.
GLENN YAGO: To what extent does the IMF create or mitigate risks in this market?
HENDRIK KRANENBURG: There has been a lot of focus on financial institutions and the risks in the way financial systems, in Asia or in various Asian countries, have been constructed as a key element that led up to the crisis. There's also been commentary on the role of ratings. I would like to share a couple of views on what the environment looked like going into the crisis, both for banks and corporates in the region, and then draw some implications for those who were involved in analysis, either on the fixed-income or equity side. Finally, I will comment on the systemic issues.
First, I am considering Japan as being "in Asia." The fundamental lesson is that it was no surprise that Japanese banks and other banks across the region encountered serious difficulties. Banking institutions in Asia have long been recognized as having significant risks, particularly in the property portfolio. In countries like Korea, there were high degrees of leverage in the corporate portfolio. And if you compare the ratings distribution of Asian banks to the distribution for bank ratings in Europe or in North America, clearly banks in those two latter regions distribute much more in the single A, double A category. Banks in Asia have long been recognized as having riskier profiles.
There has also been a lot of discussion about the way Japan has or hasn't moved quickly enough to reform its financial system. Japan does need to stand out as one country that has allowed institutions to fail. And there are other countries in the region that have done that. A major issue is that domestic market confidence is sometimes lost when this takes place. Japanese regulators are wrestling with issues that reflect the consequences of the collapse of Hokkaido Takushoku and Yamaichi Securities. Those two institutions clearly were the weakest links in the convoy going into the crisis. The fact that those two failed should actually be seen as progress in the sense that the Japanese system allowed an analysis of risk and allowed institutions to fail.
Turning to the corporate sector, there is evidence that corporates can survive even when they fail to pay their banks. The fundamental trend is a growing number of corporate credits with ratings in the region. What underlies that is a growing credit culture in the region and a growing use of objective analysis by lenders and investors in Asia, not only for cross-border purposes but also domestically in systems like Japan and in Taiwan, to look at credit risk and seek to price assets accordingly.
Clearly throughout the region, financial system stress has been at the heart of the meltdowns that we've seen. When there is systemic stress and illiquidity, all of the work that goes into differentiating credits and types of issuers falls apart because the system as a whole is at risk. The best and the worst all seem to collapse together. The issue in many of these countries has been one of illiquidity, and that has been a fundamental risk that increasingly needs to be incorporated to the way analysts look at investments. It also means that debt and liquidity management are increasingly important for banks, for corporates, and for sovereigns. Certainly debt mismatches have featured prominently in a number of the corporate bankruptcies and indeed some of the most stressed financial institutions. We do believe that credit differentiation remains important, but it can be overwhelmed by systemic liquidity problems.
Transparency needs to be a risk factor in the investor's equation. Calls for the governments to enhance transparency ring a little hollow. I know many lenders who would prefer not to have transparency in their effort to improve their own knowledge of a situation and position in the marketplace. So, if investors do value transparency, it seems to me that it is up to them to call for it.
In emerging markets, there will be volatility in the credit situations and in credit ratings. Clearly the modern environment of capital flows and short-term capital flight exacerbate this problem of systemic liquidity. The heart of the issue of the role of the IMF is that capital flows have been one added source of instability, among a number of other factors. One of them is a regulatory cliff, situations in which regulations have a binary impact. They are a "go" or "no-go" situation. In the ratings industry we are very familiar with the impact that movement from triple B to double B can have on a credit like Korea. With a movement in the rating, it actually accelerates the institutional outflow that exacerbates the liquidity crisis.
Finally, default inexperience is a real issue for a number of the institutional investors. Having as major investors the insurance companies and pension funds that don't have the experience with non-U.S. defaults or with sovereign defaults that the banks do contributes to volatility. It contributes to a rush to the exit when things seem to be turning south.
The final message is just that we need increased recognition and differentiation of risk. The role of the IMF should be to encourage all institutions to engage in that. It is unfortunate that the IMF is regarded as a way to bailout. The emphasis should be on providing liquidity in the pricing of goods, services, and capital, and not on the role of being the ultimate bailout lender.
STEVEN HESS: The rating agencies, by giving their opinions to investors in the form of ratings, do play a role in the direction and magnitude of international capital flows. Of course our opinions are only part of an investment decision, so it is hard to quantify exactly how large the role of the rating agencies is in that regard. Nevertheless, there recently has been a whole spate of articles in the press criticizing the rating agencies for not giving an early warning of the East Asian financial crisis and therefore for causing capital inflows into the region to be greater than they would have been otherwise, making the problem even deeper than it would have been. Rick Kranenburg's and my firm are prominent in having been blamed for this.
At Moody's, in retrospect, we do believe that some of our ratings were probably too high just prior to the outbreak of the crisis—although we did have the lowest ratings in the industry for Thailand, Korea, Indonesia, and Malaysia at that time. In addition, I think we had given some very clear warnings to the market, especially about Thailand and Korea. In September of 1996, about 10 months before the Thai devaluation, we downgraded the short-term rating for Thailand. In February 1997, we placed the country's long-term debt rating on review and downgraded it in April. During the time that our rating was under review for Thailand, an article in the International Financial Review said many disagreed with Moody's view of Thailand's credit rating. So, we did have this warning that I think was fairly clear, and we had identified the risk correctly, although I have to admit, the rating was absolutely too high. We were, however, moving in the right direction and pointing out the risks involved.
In the case of Korea, in 1996, we had a report that very clearly discussed the buildup of short-term debt and the vulnerability of the country. And in June 1997, still before the initial Thai devaluation, we published a press release announcing a negative outlook for Korea's rating. It stated that Korea's sovereign rating outlook had deteriorated in view of the vulnerability posed by the weakening health of the corporate and banking sector, accompanied by a short-term external debt that had grown to twice the level of international reserves.
So, we think that the warnings in these two instances, at least, and there are others, were fairly clear and to the point. Nevertheless, the ratings were probably too high at the time. And the ratings were too high, because like everyone else, we did not foresee how sudden and how large the shift in investor confidence would be, even though we clearly had stated that these two countries were vulnerable to a shift in investor confidence. As a result of that, in the future, the weight that we place on short-term liquidity in our analysis of countries is going to be greater than it was in the past.
Another reason that the ratings were too high was, perhaps, that despite the experience in Latin America in the 1980s, we did not take fully into account the contagion effect, which was much greater and much quicker than anyone had anticipated. It was exacerbated by the rather gratuitous devaluation of the new Taiwan dollar, which came out of the blue.
I would also like to say a few words about how the IMF affects Moody's ratings. In many countries, where there is a doctrine of too-big-to-fail, or where one way or another it is explicit or implicit that the government will not allow banks to fail, our ratings have to take that into account. Therefore, the ratings are somewhat higher than they would be if the bank was analyzed on a stand-alone basis. We make that explicit in our report. But we also have a second ratings scale at Moody's called the financial strength rating; this is for banks. This is an analysis of the stand-alone position of the institution.
The IMF plays a role in global financial markets that is rather similar to that of a national government vis-à-vis its own banking system. This is the double moral hazard that Professor Becker was referring to. For us, when we believe that IMF support is coming, it is a factor in the ratings, which, after all, measure default risk. If you think that there is a rescue package on the way, the risk of default is less. It's worth noting right now that no Asian government has yet defaulted in this whole crisis, although, in my view, Indonesia is coming close; it is, by the way, the lowest-rated country in the world at this time.
We are now, as a result of all this, considering developing a ratings scale for sovereigns analogous to the financial strength rating of banks. This would seek to measure the country's ability to sustain its external financial position independent of foreign aid or the IMF. So, it would indicate whether or not a country was headed for a situation where it might be bailed out. But it would not directly measure default risk.
GLENN YAGO: If you could develop that financial strength rating, would one factor be the level for which the country is developing its domestic economy, democratizing capital, or opening up its access to capital more broadly in terms of nonstate ownership and development?
STEVEN HESS: Sure. All those factors are already in the ratings that we give now. But in addition we ask, what outside support is this country going to get? That raises the ratings to a higher level than they would be otherwise.
JAMES BARTH: Do you believe the IMF itself is not being transparent enough? It has information that firms like your own do not possess. If the IMF released such information, could it be incorporated into your ratings to enable you to perhaps do a better job rating firms and countries?
STEVEN HESS: The IMF is becoming much more transparent now. If you look at their website they now have regular press releases, and a lot of financial data is released every time they go on a consultative Article IV mission to a country; they release their report, which they didn't use to do at all.
JAMES BARTH: But only with their permission.
STEVEN HESS: I think there is some editing in there; it does not necessarily have all the details that you would like to have. In our own case, I think we generally have access to much of the same information. We would certainly favor the IMF publishing virtually everything that would make their life difficult, I presume.
JAMES BARTH: Would you prefer that the IMF, as some people would prefer, actually rate the countries itself?
STEVEN HESS: Of course, we think that we can serve that function. But another rating scale from the IMF could be useful. We don't mind competition.
HENDRIK KRANENBURG: I think the IMF has actually said they find that to be a conflict of interest to them.
PAUL HOLDEN: There are two issues. One is that when the IMF begins to publish its reports, the frankness of the reports goes down. When I was at the IMF, when reports were not published, we always compared ourselves with the OECD (Organization for Economic Cooperation and Development), whose reports were published on a regular basis and which went through extensive vetting by the government in question, as do IMF issues. The meetings are all ministered and then the governments vet the minutes. Sometimes governments are less than frank. In the Mexico crisis, the Mexican government never let on the extent to which their international reserves had been depleted. These were confidential data.
STEVEN HESS: Not to mention Korea.
PAUL HOLDEN: So there are some confidentiality issues. And if the IMF begins publishing those things, then it is going to be hampered by even less frankness by the governments that are getting themselves into trouble. So it is a tricky issue.
RAYMOND MIKESELL: Reference has been made to bailouts by the IMF. Originally the purpose of assistance by the IMF was not bailouts for countries experiencing a capital market and debt crisis. What evolved was something quite different. I want to provide a little history and raise the question of whether we should look at the IMF's function mainly in terms of dealing with immediate crises.
I do not think that the IMF can deal satisfactorily with capital crises. I think it should deal with problems that are much more fundamental. A major criticism of the large loans that the IMF has been making to East Asia and that it made to Mexico in 1995 is that these loans finance short- or medium-term debt repayments or speculative short-term capital flight. This contrasts with financing current account deficits, which was initially the primary purpose of financial assistance by the IMF.
The question of whether the IMF should finance capital movements, or whether it should only finance only imports of goods and services when they exceed current export earnings plus long-term capital imports, is an issue and source of dispute within the IMF that goes back to the beginning of its operations. As one of the few surviving participants in the 1944 Bretton Woods conference, as well as being present at debates between Harry White and John Maynard Keynes back in the early 1940s, I will engage briefly in my academic propensity to cite history.
The IMF evolved from Harry White's plan of 1942, which was designed to promote a world of stable exchange rates, free from exchange controls that impede trade and foreign investment. Under the White plan, the IMF would provide foreign exchange to a member when needed to meet an adverse balance of payments, predominantly on current account. But White did avoid any specific requirement of exchange controls or capital controls as a condition for obtaining foreign exchange from the IMF.
Keynes' Clearing Union, which was the major rival proposal for creating a post-World War II financial order, also provided that the clearing union would not cover member deficits unless they were current account deficits. Members were required to control their outward capital movement. In fact, Keynes argued that all countries, including the United States, should adopt exchange controls—but that was related to his desire to perpetuate the sterling bloc, which he was not able to do.
A compromise position between White and Keynes was embodied in Article VI of the IMF Charter, adopted at Bretton Woods. This states that a member country may not use the IMF's resources to meet a large or sustained outflow of capital, and that the IMF may require a member country to exercise exchange controls or some form of capital controls to prevent such use of the IMF's resources.
Shortly after the IMF started operations, the problem of how Article VI should be interpreted came up; there were a series of interpretations, but no formal rules. Over the next decade a number of cases arose involving the application of Article VI. An early one was in 1954 when Mexico applied for a standby credit at a time when the country had both a current account deficit and a very strong speculative outflow of capital, which was really the basic problem. But Mexico did not employ capital controls; it was one of the few Latin American countries that did not at that time. Mexico's request was approved because Mexico agreed to devalue the peso in order to correct the current account deficit. In 1956, Britain requested a substantial drawing to deal with the loss of confidence in sterling during the Suez Canal crisis. The IMF approved Britain's request, but on the grounds that it needed to restore confidence in sterling rather than to finance a current account deficit, which it really did not have.
STEVEN HESS: That seems to indicate that Lord Keynes, Harry White, and those of you discussing it at the time felt that the IMF could have been put into a position of subsidizing capital flight rather than constraining it?
RAYMOND MIKESELL: Neither Keynes nor White believed that the IMF should subsidize or finance substantial capital flight. What both had in mind with regard to IMF assistance was that if a country incurred a deficit—and they usually thought in terms of a fall in export prices or of some internal condition that would cause the country to have a current account deficit—the IMF would provide assistance. The deficit would be financed while the country adopted the necessary measures, such as changing its exchange rate and its policies, to correct the deficit. They looked only at the deficit on current account because the country could not promote growth and full employment unless it had sufficient imports.
