On Lenders' Responsibility in Currency Crises: Lessons for Japan

Takatoshi ITO (Professor, University of Tokyo)

IMF's Warning to Argentina

On March 20th, the IMF as well as the U.S. government publicly warned Argentina that there would be no additional financial support for that country unless Argentina undertakes necessary reform to deal with its crisis.

This warning was to prevent market expectations from overheating due to the Argentina government's repeated statements as if the IMF were about to reopen its financial support for that country. In any case it is quite rare that the IMF issues such a warning to any country. In response to this warning, the Argentine peso declined beyond three pesos to the U.S. dollar.

Argentina had managed to avoid devaluation of its currency despite a series of financial crises in Mexico, Asia and Brazil. It was explained by many economists that a secret to the avoidance of a currency crisis would be the "currency board system," in which domestic currency issues are backed by foreign reserves.

However, Argentina did encounter a currency crisis in 2001 and was forced to abandon at the beginning of 2002 its fixed exchange rate of one peso to the dollar, which had been maintained for a decade. After all, that was a result of the classical problem of fiscal deficit and overvaluation of the exchange rate.

The budget deficit in the government sector in Argentina as a whole has been around 3-4 % relative to GDP. Its major trading partners include its neighbor, Brazil, and Europe, with which Argentina has a strong historical tie. Brazil devalued its currency by 40 % in 1999, and the Euro has been depreciating more than 20 % since its introduction in January 1999. As a result, Argentina, while maintaining its fixed exchange rate against the U.S. dollar, has been losing its competitiveness, and thus its exports stagnated and its growth rate became negative.

In 2001, Argentina lost its foreign reserve by about 11 billion dollars from January through August, and its foreign reserve was 14.4 billion dollars as of July 31st. In September, the IMF decided on a total of 20.6 dollars as its additional financial support for that country, while keeping its fixed exchange rate system intact, and immediately disbursed 6.3 billion dollars to bail out Argentina. However, no promised reforms were carried out, and the economic conditions deteriorated. The foreign reserve declined to 14.7 billion dollars, implying that the amount of money given by the IMF vanished by capital flight.

Argentina tried to adopt various measures in order to manage its crisis. In December, when the crisis deepened rapidly, restrictions on deposit withdrawal were imposed and the issuance of a new currency (devaluation in effect) was considered. However, the IMF questioned its effectiveness and did not carry out the financial support that was originally planned in December. The government declared a moratorium for its debt and the crisis entered into a serious stage.

In January 2002, the currency board system was finally abandoned. A dual exchange rate system was adopted temporarily, but the country was forced to move to the floating system in February.

There are so many problems that Argentina has to deal with from now on. Those include negotiations for rescheduling of government obligations, clearing of banks' credit-debt relations, lifting of the restrictions on deposit withdrawal, revision of the bankruptcy law and abolition of quasi-money issued by local governments.

The Argentine crisis broke the myth that the currency board system for developing countries would be immune to a crisis. Actually, the main reason why the currency board system strengthened the credibility of the currency was the fact that it placed an automatic restriction on the issuance of the currency. Therefore, the currency board was an effective system for a country that suffers from high inflation.

However, the currency board system has two fundamental problems that are shared by the fixed exchange rate system. First, this is essentially a peg system. If, therefore, the dollar to which the local currency is pegged is overvalued, then the export competitiveness of this country (Argentina) will decline and its current account balance will deteriorate. In order to prevent this from happening, it is necessary to have high flexibility of prices and wages as well as a sound financial system that can endure deflation.

Second, monetary policy could not be used to stimulate the economy in times of recession or to curb overheating in times of economic expansion. This is because the interest rates in the key-currency country (say, the United States) to which the local currency is pegged automatically apply to the currency board country. If, therefore, the business cycle differs from that in the United States, it would become quite difficult to stabilize business fluctuations. Even with regard to the supposedly superior aspect of the currency board system to the fixed exchange rate system, that is, to obtain greater credibility of the currency, domestic investors could send their money overseas and the country's foreign reserve might become depleted once they lose confidence in their own currency. It is generally robust to speculation by foreign investors, but it is quite vulnerable to capital flight by domestic investors, as actually happened in Argentina.

Krueger Proposal for a New System

Toward the end of last year, IMF First Deputy Managing Director Anne Krueger expressed her "personal opinion" in her public lectures and suggested a new direction for managing sovereign debt crises. The main point of her suggestion is that a new system should be introduced such that the IMF could approve a temporary standstill on sovereign debt while debt rescheduling is negotiated, if there is a possibility of sovereign default in a developing country.

In the present system, the default of government obligations might lead to legal complications such as law suits by government bond holders to seize government assets. Therefore, IMF member countries should be able to stop law suits while a temporary standstill is imposed. Also some IMF chapters should be revised in such a way that creditors could reschedule their credit by collective action. On the other hand, the IMF should supervise debtor countries to negotiate on rescheduling plans faithfully.

The IMF has so far tended to prevent a currency crisis from happening and to prevent contagion to neighboring countries once a crisis happens, by injecting as much fund as possible to the country in crisis. However, there has been much criticism that such a measure would only bail out those investors who gladly purchase short-term high-interest government bonds that are issued by a developing country for inducing capital inflow and buying time when they face an imminent crisis. The logic here is that investors should share their fair burden in case of default, because high interest is a reward for default risk.

The Krueger proposal is worth examining carefully in that it suggests the direction of private sector involvement, or to ask lenders to share responsibility for managing a crisis. While Dr. Krueger did not specifically refer to any particular country, we should take note of the fact that the Argentine crisis happened while the IMF was searching for a new direction to deal with such a crisis.

Careful Management of Investment Risk

There seem to be three lessons for Japan. First, it is important that Japan as the world's largest creditor nation with huge amounts of private and public credit to various nations should actively participate in discussions on reform of the international currency system in the future. If there is an increasing number of default cases that are "officially" approved by the IMF or major advanced countries in the future, there is a possibility that rules against Japan's interests might be adopted unless Japan actively participates in rule making with close collaboration with other creditor nations.

Second, Japanese investors need to take the utmost care of managing risk for future investments in developing nations as well as the outstanding balance of past investments. Most of the holders of yen-denominated bonds (Samurai bonds) issued by the Argentine government in September 2000 are supposedly Japanese corporations and individuals. It is questionable whether bond holders fully recognized the default risk by the Argentine government, and, furthermore, there is some doubt whether terms of issues were based on appropriate risk assessment at the time of issuance in September 2000.

It has been pointed out that, generally speaking, the spread for the Samurai bonds (yield differentials compared to Japanese government bonds) is insufficient in view of its risk. It is important that Japan should not provide too easy a way out for those countries that are desperate in raising funds to avoid default.

Third, for a country to which Japan offers its ODA or long-term private investment such as direct investment, we should carefully oversee the country's government policies. Japan has so far tended to offer much money but no voice. However, such an attitude is no longer appropriate in the current trend for more emphasis on lenders' responsibility. In this regard, we might as well reform our concept of foreign economic assistance of Japan.

(Translation of the original Japanese article that appeared in the February 22, 2002 issue of Nihon Keizai Shinbun)