Global Policy Forum

By George Soros

It is a distinguishing feature of the financial crises of the past 20 years – the international debt crisis in 1982, the Mexican crisis of 1994, the emerging-market crisis of 1997-99, and now the crisis confronting Argentina and Turkey – that they have been confined to the periphery of the world economy. This has caused a tremendous disparity in economic and financial performance. While the periphery has gone from crisis to crisis, the center has remained remarkably stable and prosperous. What accounts for this, and what should be done?

Historically, financial crises have typically led to greater regulation, including the advent of central banks and other supervisory agencies. In countries at the center of the world economy, these institutions are now mature enough to avert financial dislocations comparable to those of the 1930s. But the development of the international regulatory framework has not kept pace with the globalization of financial markets. Indeed, the crisis of 1997-99 can be at least in part attributed to the premature opening up of the capital markets of developing countries before their financial institutions were equal to the task.

Since the crisis of 1997-99, the importance of strengthening regulatory mechanisms in emerging market economies has been emphasized but the international regulatory mechanism has been, if anything, weakened. There is a widely held view that IMF rescue packages have actually contributed to the crisis by creating what economists speak of as "moral hazard" – the expectation by market participants that the IMF could be counted on to rescue countries in trouble, and thus to bail out investors who provided credits to them. The IMF's rescue packages, according to this view, weakened market discipline, encouraging an irrational and unsustainable lending boom.

There is some merit to this argument. But market fundamentalists are wrong in claiming that eliminating moral hazard is all that is required to put the international financial system on a sound footing. The system is heavily tilted in favor of the center – primarily the United States – which is in charge of setting monetary policy. Eliminating moral hazard merely allows the inherent disadvantage of the periphery to be reflected in the cost and availability of capital. This has already happened, although it is not yet acknowledged.

In the course of the 1997-99 crisis and its aftermath, the IMF has performed a volte face, going from "bailing out" to "bailing in" the private sector. The cost of burden-sharing has been factored into market prices. As a result, the risk premium for emerging market finance has risen significantly and the risk/reward calculation has shifted against investing in emerging markets.

The change in IMF policies would have been successful in preventing a recurrence of the emerging market boom but it has already created a problem which works in the opposite direction: the high cost and unavailability of capital is itself a new form of financial contagion. It manifests itself not only in the lack of foreign portfolio investments but also in the flight of domestic capital. It puts domestic companies in periphery countries at an inherent disadvantage vis-í -vis multinational corporations.

Taking resident lending, portfolio investment and private credit flows together, there has actually been a net outflow from emerging markets since 1997 – which has gone from a positive $81.7 billion in 1996 to a negative $104.7 billion in 2000, offset by slightly larger inflows of foreign direct investment and by official financing. A staggering 64% of global net capital exports in 2000 flowed to the United States in search of better investment opportunities, compared to an average of 35% in 1997-99.

Clearly it is not enough to eliminate moral hazard in global finance; new incentives need to be introduced to create a more level playing field and encourage the flow of capital to periphery countries. The incentives should take the form of credit guarantees and other credit enhancements which would reinforce the power and influence of the IMF in preventing future crises.

The general principles are obvious: There ought to be a better balance between crisis prevention and intervention and a better balance between offering incentives to countries to follow sound policies and penalizing those which do not. The two objectives are connected: It is only by offering incentives that the IMF can exert stronger influence on the economic policies of individual countries prior to a country turning to the IMF in a crisis situation.

To implement these principles, I propose the following measures:

• The IMF should rate countries. The highest grade would make a country automatically eligible for Contingent Credit Lines and bondholders would be given an assurance that in case of an IMF program their claims would be fully respected. This would provide a powerful enhancement of the country's credit. By contrast, for countries in the lowest grade, the IMF would make it clear in advance that it would not be willing to enter into a program without private sector burden-sharing. Caveat emptor: Let the buyer beware. There could be one or more intermediate grades where the IMF may insist on various degrees of burden-sharing;

• The Basle Accord, which sets internationally agreed capital requirements for commercial banks, could translate the IMF ratings into variations in capital requirements;

• The Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan could accept at their discount windows designated treasury bill issues of selected countries. This privilege could be reserved for specific countries or particularly perilous situations.

Several legal issues must be resolved to make these changes effective. For example, the IMF currently has no power to impose burden-sharing, nor can it offer bankruptcy-type protection against creditor suits during debt re-organizations (United States Secretary of Treasury O'Neill recently indicated support for such a mechanism).

These reforms would give the IMF and its members more effective tools to prevent international financial crises and reduce the economic disparity between countries at the center of the global system and those at the periphery. To implement them, we must first overcome the objections of market fundamentalists who want to eliminate or downsize the IMF.

George Soros is Chairman of the Open Society Institute and of Soros Fund Management.

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