Financial Post G7 Record

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[Financial Post G7 Record]

Financial Post, Weekly edition, Sat 10 Jun 95, page 12

Keywords: International finance History Economic summits World Halifax Corporate restructuring International Monetary Fund World Bank

DOES THE G-7 MATTER ANY MORE?: Global leaders will try to grapple with a Pandora's box-currencies, trade issues and even the spectre of another global recession

Greg Ip

The global economy was simpler 30 years ago. Currencies were fixed. Balance of payments deficits were modest, as were flows of capital. Devaluations were strictly controlled by the International Monetary Fund. The pockets of the U.S. were deep enough to handle any disruption to the world financial system.

By those standards, the current economy would be unrecognizable. Currency crises are weekly events. In the past few years, the world has seen 500%-interest rates, US$50-billion bailout packages, and the wealthiest of municipalities going bust on market bets gone bad. An enormous torrent of capital pours in and out of world financial centres daily.

When the leaders of the world's seven largest economies meet in Halifax this week, there will be a note of '60s nostalgia. One way or another, most of their proposals will be aimed at giving governments a little more control. The systems put in place in a simpler time just don't cut it anymore.

Among the proposals are giving the IMF more money to bail out distressed economies, enabling it to act faster, reforming the World Bank, and perhaps altering the worldwide exchange rate. Whether any of these would make things better is a matter of debate. Many believe they would make things worse by delaying reforms necessary to prevent crises in the first place.

Still, Canadian Prime Minister Jean Chretien - the leader of a country freshly scarred by the Mexican currency crisis - is determined to produce something substantial in the way of reforming international financial institutions.

U.S. President Bill Clinton didn't know how prescient he was last year when, a few weeks before the G-7 summit in Naples, he proposed devoting the Halifax event to ''global governance.'' At that time he had no idea the peso would collapse and suddenly make that woolly issue critical.

The way the peso took the C$ with it and drove up Canadian interest rates demonstrates how Canadians can be directly affected.

Gilbert Winham, a political scientist at Dalhousie University in Halifax and co-editor of a book on summit issues, was asked by a reporter last week what it all means for the widget maker in Truro, N.S.

''We're all interested in financial stability and instability,'' Winham answered. ''If it can happen to Mexico, it can happen to Canada. Our currency has been driven down and the possibility of crisis is real. We're clearly getting more vulnerable to shocks.''

Here's a summary of the issues on the table:

The IMF - It was created in 1945 at the Bretton Woods conference to maintain fixed exchange rates and give financing to countries having trouble with balance of payment deficits. The system of fixed exchange rates ended in 1971, but the IMF's financing duties have grown.

The world has changed profoundly since 1945 and one of the biggest changes is the vastly increased volume and mobility of capital. This has made it much harder for governments to manage their economies. In response, some say the IMF must get bigger, richer and faster.

The Mexican crisis demonstrates the need. Mexico had already nearly depleted its foreign exchange reserves when last December, it devalued the peso. The unexpected devaluation prompted foreign investors to liquidate their holdings en masse. Interest rates skyrocketed, the peso went into a freefall and Mexico was on the brink of defaulting.

In February, the U.S., IMF and several other countries put together a US$50-billion package of loans and loan guarantees to enable Mexico to refinance its foreign debt. It was the largest such bailout in history, and its size relative to the IMF's available capital of US$80 billion underlined the severity of the modern financial crisis.

Most backers of the IMF and the IMF itself think it should have more money for dealing with such disasters, and a faster process for lending it. In a draft of their communique leaked this week, the G-7 leaders promise to create an ''Emergency Funding Mechanism'' to speed up aid to countries in distress, in larger amounts than now available. They also recommend doubling the General Agreement to Borrow, in effect a $36-billion IMF line of credit with the central banks of the G-7 and four other countries. In brackets (implying the leaders had not yet fully agreed), the communique urges the IMF to consider tapping private capital markets.

A fourth method of increasing resources, a new issue of the IMF's own currency, so-called Special Drawing Rights, was not included. SDRs are distributed among the members and can be used by them to acquire foreign currency or repay IMF loans. Since issuing SDRs is in effect printing money, the rich countries have blocked this out of concern about inflation. This has angered developing countries, who use SDRs as an important source of foreign currency.

The proposals for reform are arousing criticism from some quarters, as reflected in U.S. congressional opposition to Clinton's Mexico bailout.

Critics say bailing out bankrupt economies creates the ''moral hazard'' of encouraging behavior that leads to bankruptcy.

In a publication of the Shadow Open Market Committee, a U.S. think-tank, Lee Hoskins, a former president of the Federal Reserve Bank of Cleveland, says Mexico has suffered three crises in the past dozen years brought on by bad policy, and the U.S. has responded each time with ever-increasing sums of money.

''These loans provide a short-term palliative while creating perverse incentives for Mexican officials and foreign investors that ensure the 'crisis' will reappear on an even larger scale in the future . . . The regular practice by the U.S. government of extending guarantees to countries experiencing financial difficulties underwrites policies in these countries that otherwise would be untenable. It sends a message to investors . . . that they can invest with little fear of total loss.''

Lawrence Summers, U.S. treasury undersecretary, responded to those charges in a satellite interview with foreign reporters Wednesday. ''I'm not one of those who believes we should abolish fire departments to prevent people from smoking in bed. A balance of risk must be struck. The absence of a capacity to respond to emergencies would outweigh the moral hazard costs.'' Besides, IMF aid would come only with many strings attached, he said.

The IMF is also being asked to keep a closer eye on problem countries. It is widely believed the Mexican crisis was intensified by the surprise factor.

Wendy Dobson, director of the University of Toronto's Centre for International Business, says so far, the IMF simply hasn't carried out surveillance of countries that weren't borrowing from it, as Mexico wasn't last year. ''It's surprising the question wasn't asked somewhere in the IMF process, 'OK, who's headed for trouble?' It's a simple question and doesn't need a lot of analysis.''

Many want the IMF to stop being so secretive. It could start by publicizing its annual reports on member countries, which are currently confidential, says Dobson.

The World Bank - Created at the same time as the IMF, its job was to supply loans to developing countries for projects that the private sector would not finance.

However, in recent years, private investment in developing countries has risen dramatically and, in most regions, outweighs assistance from the World Bank and other development agencies. The World Bank may eventually be asked to curtail its lending significantly to private- sector projects, except those that have no chance of attracting other financing.

Other Institutions - The IMF and World Bank are two of the better known in a plethora of international bodies with various responsibilities. The United Nations in particular has many economic agencies.

Detailed discussion of the UN has not been included in this year's summit agenda. But John Kirton, a political scientist at the University of Toronto specializing in summits, thinks they should be subjected to same scrutiny as Canada's own social programs.

''Shouldn't we look at them and ask for some value for money, and consider an international program review?'' Kirton says. Canada has little influence in or benefit from many. For example, it is the second- largest contributor to the Organization of American States, but out of 588 staff members only two are Canadian. ''And no one can make the case the OAS is an effective institution,'' Kirton adds.

Many UN agencies, such as the UN Commission on Trade and Development, overlap functions performed by the IMF, World Bank or World Trade Organization and could be dissolved.

The exchange rate system - Japan, Canada, France, Italy and Britain have all taken their lumps from exchange rate troubles in recent years. This has prompted some economists to propose a return to fixed or partly fixed exchange rates.

In particular, John Williamson and Fred Bergsten of the Washington-based Institute for International Economics have been proposing ''target zones'' - wide bands that would allow currencies to rise and fall 10% against one another. That would provide considerable freedom for monetary policy to adjust interest rates as the economy requires, while avoiding the egregious under- and over-valuations that cause so much trouble.

Kirton thinks Chretien has an abiding interest in fixed exchange rates and may raise the subject in Halifax. ''He's not wedded to a particular formula. He does want greater political management'' of exchange rates.

But there is no shortage of people ready to slam such proposals.

''The notion that an IMF-type organization, this group of global bureaucrats, would somehow second guess the international financial community is just laughable,'' says Michael Walker, executive director of the Fraser Institute.

Trade - The U.S. and Japan are supposed to keep their dispute over automobile trade away from the summit. With the U.S. isolated in its decision to slap 100% tariffs on Japanese luxury cars but unwilling to lose face, the dispute does not appear headed for early resolution.

The completion of the Uruguay Round of the General Agreement on Tariffs and Trade, and subsequent creation of the World Trade Organization, has taken away some of the pressure on the trade agenda. But Winham and University of Toronto economist Sylvia Ostry say Halifax would still be a good opportunity for G-7 leaders to push the extension of privileges inside regional free trade agreements, like the European Union and North American Free Trade Agreement, to other countries. The G-7 leaders may express support for recent initiatives linking those two agreements, but the communique doesn't seem to address it.

The economy - Almost no attention has been paid in pre-summit discussion to the state of the world's economy. But it could be the sleeper issue of the year. Latest economic data suggest the U.S. and Canadian economies have come to an abrupt halt, and may be slipping into recession. The Japanese economy is also at the brink of recession.

World leaders, eternally optimistic in front of news cameras, say they do not consider a recession this year as a reasonable possibility. But they might be wrong.

Says Dobson, ''We might look back and say, this summit is one where we missed the fragility developing in the global economy.''

This information is provided by the Financial Post.
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Revised: June 3, 1995

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