[Senate Hearing 108-882]
[From the U.S. Government Publishing Office]



                                                        S. Hrg. 108-882

 
                     OVERSIGHT OF THE INTERNATIONAL
                      MONETARY FUND AND WORLD BANK

=======================================================================

                                HEARING

                               before the

                              COMMITTEE ON
                   BANKING,HOUSING,AND URBAN AFFAIRS
                          UNITED STATES SENATE

                      ONE HUNDRED EIGHTH CONGRESS

                             SECOND SESSION

                                   ON

  PROPOSALS TO REFORM THE INTERNATIONAL MONETARY FUND AND WORLD BANK, 
 INCLUDING THE COSTS AND BUDGETARY TREATMENT OF MULTILATERAL FINANCIAL 
                        INSTITUTIONS' ACTIVITIES

                               __________

                              MAY 19, 2004

                               __________

  Printed for the use of the Committee on Banking, Housing, and Urban 
                                Affairs


      Available at: http: //www.access.gpo.gov /congress /senate/
                            senate05sh.html


                                 ______

                    U.S. GOVERNMENT PRINTING OFFICE
25-174                      WASHINGTON : 2006
_____________________________________________________________________________
For Sale by the Superintendent of Documents, U.S. Government Printing Office
Internet: bookstore.gpo.gov  Phone: toll free (866) 512-1800; (202) 512ï¿½091800  
Fax: (202) 512ï¿½092250 Mail: Stop SSOP, Washington, DC 20402ï¿½090001


            COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

                  RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah              PAUL S. SARBANES, Maryland
WAYNE ALLARD, Colorado               CHRISTOPHER J. DODD, Connecticut
MICHAEL B. ENZI, Wyoming             TIM JOHNSON, South Dakota
CHUCK HAGEL, Nebraska                JACK REED, Rhode Island
RICK SANTORUM, Pennsylvania          CHARLES E. SCHUMER, New York
JIM BUNNING, Kentucky                EVAN BAYH, Indiana
MIKE CRAPO, Idaho                    ZELL MILLER, Georgia
JOHN E. SUNUNU, New Hampshire        THOMAS R. CARPER, Delaware
ELIZABETH DOLE, North Carolina       DEBBIE STABENOW, Michigan
LINCOLN D. CHAFEE, Rhode Island      JON S. CORZINE, New Jersey

             Kathleen L. Casey, Staff Director and Counsel

     Steven B. Harris, Democratic Staff Director and Chief Counsel

                Skip Fischer, Senior Staff Professional

             Martin J. Gruenberg, Democratic Senior Counsel

   Joseph R. Kolinski, Chief Clerk and Computer Systems Administrator

                       George E. Whittle, Editor

                                  (ii)
?

                            C O N T E N T S

                              ----------                              

                        WEDNESDAY, MAY 19, 2004

                                                                   Page

Opening statement of Chairman Shelby.............................     1

Opening statements, comments, or prepared statements of:
    Senator Crapo................................................     6
    Senator Allard...............................................     9
        Prepared statement.......................................    39
    Senator Sarbanes.............................................    11
    Senator Carper...............................................    17
    Senator Hagel................................................    39

                               WITNESSES

John B. Taylor, Under Secretary for International Affairs, U.S. 
  Department of the Treasury.....................................     2
    Prepared statement...........................................    39
Allan H. Meltzer, The Allan H. Meltzer University Professor of 
  Political Economy, Carnegie Mellon University and Visiting 
  Scholar, American Enterprise Institute.........................    25
    Prepared statement...........................................    44
C. Fred Bergsten, Director, Institute for International Economics    28
    Prepared statement...........................................    46
Douglas Holtz-Eakin, Director, Congressional Budget Office.......    32
    Prepared statement...........................................    48

              Additional Material Supplied for the Record

Pages from the Monetary Policy Report to the Congress, February 
  2004...........................................................    58

                                 (iii)


                     OVERSIGHT OF THE INTERNATIONAL
                      MONETARY FUND AND WORLD BANK

                              ----------                              


                        WEDNESDAY, MAY 19, 2004

                                       U.S. Senate,
          Committee on Banking, Housing, and Urban Affairs,
                                                    Washington, DC.

    The Committee met at 10 a.m., in room SD-538, Dirksen 
Senate Office Building, Senator Richard C. Shelby (Chairman of 
the Committee) presiding.

        OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

    Chairman Shelby. The hearing will come to order.
    This morning the Committee meets to examine the role of the 
International Monetary Fund and the World Bank. It has been 
several years since the Full Committee has examined these 
Bretton Woods Institutions which are critically important to 
the architecture of the international financial system. 
Congress has a responsibility to monitor their work closely and 
seek to influence effective policy. After all, the United 
States is the single largest shareholder in almost all of these 
multilateral financial institutions.
    Building on reform initiatives instituted after the Mexican 
and Asian financial crises, the IMF and the World Bank have 
implemented initiatives to better anticipate, prevent, and 
resolve sovereign financial crises, but obvious challenges 
still remain.
    With the recent attention, debt restructuring battles, and 
financial resources attributed to Brazil and Argentina, 
opportunities exist to focus on the strengths and weaknesses of 
these institutions and what steps can be taken to make them 
more worthwhile.
    For our first panel today, we welcome Under Secretary John 
Taylor of the U.S. Treasury. Under Secretary Taylor is the 
principle adviser to the Secretary of the Treasury on 
international economic and financial issues. Prior to serving 
this Administration, Under Secretary Taylor was the Roberts 
Professor of Economics at Stanford University. He is a globally 
recognized expert on international monetary and financial 
issues.
    Our second panel will include three witnesses: Dr. Allan 
Meltzer, Distinguished Professor of Political Economy at 
Carnegie Mellon University; Dr. C. Fred Bergsten, Director of 
the Institute of International Economics here in Washington, 
DC; and Dr. Douglas Holtz-Eakin, Director of the Congressional 
Budget Office. Drs. Meltzer and Bergsten have extensive 
experience with regard to these multilateral financial 
institutions. In November 1998, as part of the legislation 
authorizing $18 billion of additional U.S. funding for the IMF, 
Congress established the International Financial Institutions 
Advisory Commission to recommend future U.S. policy toward 
these institutions. Commonly referred to as the ``Meltzer 
Commission,'' in reference to its Chairman, Dr. Meltzer. Dr. 
Bergsten has also served on this Commission and co-authored the 
dissenting opinion.
    Dr. Holtz-Eakin's testimony will summarize CBO's ongoing 
study analyzing the Long-Term Economic Costs of U.S. Federal 
Budget Obligations. While this CBO study has yet to be 
completed, we are very interested in any preliminary findings 
Dr. Holtz-Eakin can share with us.
    I want to thank all the witnesses for appearing before the 
Committee today. And, Dr. Taylor, we welcome you back from your 
trip to Asia and look forward to hearing your testimony. I am 
hoping we will be joined by some other members of the panel.
    Your written testimony will be made part of the record in 
its entirety. You proceed as you wish.

                  STATEMENT OF JOHN B. TAYLOR

           UNDER SECRETARY FOR INTERNATIONAL AFFAIRS

                U.S. DEPARTMENT OF THE TREASURY

    Mr. Taylor. Thank you very much, Mr. Chairman.
    Chairman Shelby. By the way, you are no stranger to the 
Banking Committee.
    Mr. Taylor. No, sir. It is good to be back, and thank you 
for inviting me to testify here on the efforts of the 
Administration to put forth its reform agenda at the Bretton 
Woods Institutions, the IMF and the World Bank. Reform of these 
institutions has been a high priority of the Bush 
Administration since its beginning.
    During the first year of the Administration, we presented 
our reform agenda. President Bush, in an important speech at 
the World Bank, laid out some of the key principles and 
proposals, and then in testimony in the Congress and in 
speeches various places, we described some of the technical 
details on the political and economic rationale. I must say we 
worked together with our fellow shareholders in these 
institutions, which was very important, and with the staffs of 
the institutions as well to carry out the reforms.
    In April 2002, there was an important international 
agreement between the United States, France, Germany, the 
United Kingdom, Canada, Japan, and Italy on how some of these 
reforms would be implemented in the so-called G-7 Action Plan 
of 2002.
    Mr. Chairman, I am happy to report that an enormous amount 
of progress on this reform agenda has been made, especially in 
the last year and a half. Key reforms that have been 
implemented--and I will list five of them here--are the 
implementation of collective action clauses in sovereign debt; 
the creation of clear limits and criteria for exceptional 
borrowing from the IMF; the use of grants in replacement of 
loans from the World Bank; the introduction of a rigorous 
system for measuring results at the World Bank; and the focus 
of both institutions on their core expertise, with a better 
emphasis on division of labor between them.
    As is true of many reform movements, many of these ideas 
have been discussed and debated for years. The work of this 
Committee, in fact, has been very much part of that discussion 
and debate. But, in my view, in the last few years we have gone 
well beyond discussion and debate. What is different now is 
that these reforms have actually been adopted. Any one of these 
reforms, in my view, would represent a significant 
accomplishment. Taking them all together as a whole, I think 
they represent a fundamental shift in the way the international 
financial institutions are operating.
    The goals of these institutions, simply put, are to 
increase economic and financial stability, number one; and, 
number two, to increase economic growth and thereby reduce 
poverty around the world. These are good goals. There is no 
reason to change these goals. But the world economy and 
financial markets have changed dramatically since the 
institutions were founded 60 years ago. So in order to fulfill 
these goals, the institutions must reform. Just, for example, 
consider some of the changes just in the last 15 years.
    Securities, as distinct from bank loans, are a much bigger 
percentage of cross-border financial flows. Private capital 
flows have increased dramatically and are much larger than 
official flows from the international financial institutions. 
There has been a particular emphasis on remittances in recent 
years. As we get more and more data, we see that remittances 
alone from immigrants back home are much larger than the 
transfer of resources from the international institutions and 
other aid agencies. Then, finally, financial markets have 
become much more interconnected, and flows have become more 
volatile.
    I believe that these changes in cross-border financial 
flows have, by themselves, led emerging markets to become more 
crisis-prone. And, in fact, the number and severity of crises 
in the 1990's was up significantly compared to the 1980's.
    The initial responses to these crises by the official 
community in the 1990's were understandable. As in the case of 
Mexico, the responses had to be developed from scratch in a 
very short period of time, and they had to be implemented 
immediately. But the point I would emphasize in discussion of 
these crises is that they represented and provided very clear 
evidence that the systemic changes in the world's financial 
markets, as I just summarized, were taking place, and 
systematic changes in the operation of the institutions had to 
take place in order for them to fulfill their goals.
    A related problem was that loans from the IMF and the World 
Bank to the poorest countries in the world--the poorest 
countries in Latin America, Africa, and Asia--were building up 
to clearly unsustainable levels, and this led to understandable 
calls for debt relief. And, again, in our view, the responses 
at this time were more tactical than strategic, dealing with 
the problem at hand rather than developing a strategy to deal 
with the overall problem. They dealt with the current serious 
need for debt relief, but not with the expectations effects and 
the incentive problems that would continue to cause the 
international institutions to lend too much to the very poor 
countries.
    My written testimony, Mr. Chairman, provides the details of 
how the reforms I mentioned at the beginning deal with these 
problems, how it makes the institutions better able to deal 
with the current world environment in order to fulfill their 
goals. But I think that clear progress has been made and is 
substantial. Our review indicates that there is still more work 
to be done to lock in the reforms that I mentioned and to even 
expand on them.
    In our view, now is an opportune time to move ahead to do 
more. Why? Well, there are three reasons I would emphasize 
here. First, the recent progress in these reforms, in our view, 
working internationally with other countries, has generated a 
new enthusiasm or a new momentum for reform. There is a 
positive feeling that by working together we can actually get 
something done to change the international institutions in an 
important way. This gives us an opportunity to make further 
changes, the kind of changes that have been on people's minds 
since the 50th anniversary of the institutions, but actually 
make them take place on the 60th anniversary.
    The second reason to pursue these reforms now and to 
continue with what we are doing is that we currently are in a 
period where there are no major financial crises around the 
world. This gives us, the relevant participants, time to 
consider these longer-term reforms more thoroughly, and again, 
it seems to us that locking in and expanding on the five points 
I mentioned are the important things to do.
    The third reason is simply this is the 60th anniversary of 
the institutions. It is a time to look back and to make sure we 
got it right.
    For these reasons and others, Secretary John Snow, as this 
year's Chairman of the G-7 Ministers and Central Bank 
Governors, has called for a strategic review of the 
institutions with the aim of defining new directions for them 
to take that build on the five reforms I mentioned at the 
beginning. There has already been a very positive response to 
Secretary Snow's initiative from the developed world, from 
emerging market countries, and from the developing countries 
alike. Broad consultation is under way, so it is still too 
early for me to tell what the new directions will be over and 
above what has been accomplished in the last year and a half. 
But I will mention some examples of the ideas that are being 
well received.
    One is the possibility of developing a new nonborrowing 
program from the IMF, a program that exploits the expertise at 
the IMF but does not burden countries with loans.
    Another idea is to develop a new surveillance system with 
the IMF which would entail reorganization at the IMF and the 
encouragement of ownership and country-led proposals from the 
countries that pursue such programs.
    And, finally, to further increase the amount of grants 
going to the very poor countries, as distinguished from loans, 
in an effort to further improve their debt sustainability in 
conjunction with additional debt relief.
    The issues I have discussed here and more thoroughly in my 
written testimony, Mr. Chairman, are actually quite technical. 
Some people would consider them somewhat arcane. But they are 
deeply important to financial stability and economic growth. 
And I think, thanks to the very successful effort in the last 
year and a half as well as the actual improvement in the world 
economy, there is a willingness to consider further reform and 
to spend the time needed to get it right. Indeed, this is what 
Secretary Snow has urged us to do in the G-7 and his strategic 
review and new directions initiative.
    Thank you, Mr. Chairman. I will be happy to answer any 
questions you may have.
    Chairman Shelby. Thank you, and thank you for your written 
testimony. You are absolutely right. It is very technical, but 
very important.
    In October 2003, this Committee heard from Treasury 
Secretary Snow on the Chinese Exchange Rate Policy. At that 
time Secretary Snow was hopeful that significant concrete steps 
would be made toward a more flexible exchange rate policy in 
weeks and months to come. Now, 7 months later, you recently 
returned from Asia and reported that talks were very candid, 
very productive concerning the current economic conditions of 
China and that you remain confident that the Chinese Exchange 
Rate Policy is being addressed. Chinese leaders still have not 
announced a timetable.
    My question is this: What specific steps, Dr. Taylor, have 
the Chinese taken to address the exchange rate situation? For 
example, what have Chinese leaders done to address the problems 
in the Chinese banking system, which has been very weak and 
could become even more so in the event of a currency peg or if 
it were precipitously removed?
    Mr. Taylor. Thank you, Mr. Chairman. Just very 
specifically, the Chinese have injected some additional capital 
into two of the largest state banks, and that is in an effort 
to begin to deal with some of the nonperforming loans that they 
have to make the banks more resilient.
    More directly related to the exchange rate, they have begun 
to relax some of the capital controls on both inflows and 
outflows. They have begun to work on developing markets, better 
spot markets, but, more importantly, more futures markets which 
are needed for a good, flexible exchange rate system.
    My assessment is there is really not a debate about whether 
China will move to a flexible exchange rate. They have 
indicated they want to do that. They want to do it in a way 
that will work for them.
    One of the things that we emphasized in this recent trip is 
that the current inflationary pressures in China are another 
reason to move toward flexibility because those inflationary 
pressures are being caused to some degree by the increase in 
money growth. As always, money growth will lead to higher 
inflation. And the flexibility of the exchange rate will enable 
them to contain the money growth more than they are able to do 
now. Now, as they buy securities in the international markets 
to defend the peg, they cannot offset it completely to 
sterilize it, is the technical word, and, therefore, money 
growth is stronger than it otherwise would be.
    I think there are many reasons for them to move toward a 
flexible rate. They said they would. We are working with them 
on a technical level to make it happen as smoothly, as soon as 
possible.
    Chairman Shelby. Should we be more aggressive working with 
some of the others in the international market to help them 
shore up China's financial system as a preview of going toward 
a flexible exchange rate? Or is that something they have to do?
    Mr. Taylor. Well, we can be very helpful with our expertise 
in the United States, not only from the Government side, the 
regulators, but also from the private market side, to develop 
some of these futures markets. Markets that are for futures 
markets or forward markets are something that they are very 
much interested in. We sent a technical cooperation team to 
China in the winter. We are going to send a second team in 
June. And those discussions I would describe as quite 
technical, of course, but they are ones which are aimed toward 
creating these markets where a flexible exchange rate could 
work and where you have the price discovery, the ability to 
determine what the exchange rate will be in a full market 
system.
    So, I think it is important to be active on this, not 
passive, and to share the information we have with them and 
encourage others. A very important development internationally 
is that the G-7 countries called for more flexibility in 
exchange rates in countries that do not have such flexibility. 
That was reiterated now three times--in the Dubai meeting, in 
the meeting in Florida, and in the meeting that just occurred 
in Washington. It is a multilateral effort at this point to 
help China move to a flexible exchange rate.
    Chairman Shelby. How do they deal with the situation they 
have, basically state-owned banks making loans to failing 
state-owned industries, you know, just eating it up, 
nonperforming loans? I mean, it seems like it is a merry-go-
round.
    Mr. Taylor. It is a problem. They know as they move toward 
a market economy that they have to get the banks to operate 
more in a market environment rather than have directed loans, 
which is what they are used to. They are opening their 
financial sector to foreign banks. I visited some of the 
foreign banks that are investing in China. That is a good way 
to begin to move more toward a market system. But they now have 
very large state-owned banks which they have to begin to think 
about how they are going to have more business-oriented type of 
lending, more lending that is based on accurate risk 
assessments. And it is difficult. I believe they are trying to 
do the right thing in this regard.
    Chairman Shelby. We will have other rounds.
    Senator Crapo.

                STATEMENT OF SENATOR MIKE CRAPO

    Senator Crapo. Thank you very much, Mr. Chairman. I again 
want to thank you for not only this hearing but also this 
series of hearings which you have held on issues critical to 
the financial industries in the United States.
    I am going to make a couple of statements and maybe just 
toss out some issues that I would like to see the witnesses 
discuss. But I have to go to a markup in about 5 minutes in 
another Committee, and so I apologize for that.
    I do want to reiterate my extreme interest in these issues, 
and I want to follow up just briefly on the line of questioning 
that you raised, Mr. Chairman, with regard to the exchange 
rate, and Mr. Taylor and the other witnesses.
    It seems to me that while we wait for China to stabilize 
its banking system and move to a floating currency, the United 
States continues to suffer from the impacts of China's actions 
in Asia on other countries as well as on the United States of 
its exchange rate. And it seems to me that there is something 
more that we can and should be doing. I am not sure what that 
something is.
    I note that Mr. Bergsten in his testimony suggests that 
China should go to an immediate one-time revaluation of 20 to 
25 percent. I personally think that would be a good idea. I am 
not sure how we would cause that to occur. But I think what I 
am asking is: Is there not something more that we can do to try 
to address this issue than simply hope and work together as 
best we can to help strengthen China's banking system and 
encourage them to move at some distant date to a floating 
exchange?
    Mr. Taylor. Senator, I think we are being quite active with 
them, and it is more than simply talking. It is doing. They 
have done a number of things to begin to open their capital 
account to allow more foreign investment in the financial 
sector. Those are all good things for us and for them. And in 
terms of the flexible exchange rate, that is what we have 
argued very precisely about. We have gotten lots of support 
from other countries around the world. We have emphasized it is 
a global issue. It has to be addressed, and it has to be 
addressed soon.
    I think our strategy is one that emphasizes the flexibility 
of the exchange rate, and that will bring about the needed 
adjustment when it occurs. At this point it seems to me it is 
the right approach and it is working.
    Senator Crapo. Are you familiar with Mr. Bergsten's 
recommendation of an immediate revaluation?
    Mr. Taylor. Yes, I am.
    Senator Crapo. What do you think of that?
    Mr. Taylor. What we have argued is that the flexibility 
itself is important, not just the revaluation. Flexibility is 
important. Now, that may or may not bring about a revaluation. 
Right now the central bank is buying foreign-denominated 
securities which suggests upward pressure on the RMB. So in 
most people's estimation, more flexibility would indeed bring 
about an appreciation of the currency and that may be what the 
Chinese want to do eventually. But if it is simply a 
revaluation, then it is a revaluation to another fixed exchange 
rate, which brings about a lot of the same difficulties that 
are being created by the current fixed exchange rate.
    So the flexibility is important, and that is the key 
globally to get the benefit from China's strong growth, which 
is benefiting the world economy, without the disadvantages and 
the distortions that a fixed exchange rate causes.
    Senator Crapo. Thank you.
    Mr. Chairman, as I indicated, I have to go to a markup 
right now, but I just wanted to conclude with a statement.
    Chairman Shelby. Absolutely.
    Senator Crapo. Several years ago, we had some pretty 
intensive hearings with regard to the recommendations of the 
International Financial Institutions Advisory Commission with 
regard to the World Bank, and Mr. Meltzer was at those 
hearings, Mr. Bergsten was at those hearings.
    I am concerned that we have not made very good progress in 
terms of implementing the recommendations of that Commission. 
And at the time I was very convinced that the Commission was on 
the right track in getting us the kinds of recommendations that 
we needed to follow in terms of getting more accountability 
and, frankly, more understanding of what is happening inside 
the World Bank in particular, but the International Monetary 
Fund as well. Mr. Meltzer, I note that, in your testimony today 
you are going to discuss that. Unfortunately, I will not be 
here to listen to that, but I have staff here and I have read 
your written testimony, and I will be following very carefully 
what you say.
    I just wanted to say to all the witnesses and to the 
Chairman and the other Members here that I am very concerned 
that we have not, either as a Congress or as the 
Administration, taken the necessary steps to be aggressive 
enough in the reforms with regard to the recommendations that 
we have already received that to me seem to be very evident in 
terms of their need. And I for one am going to be focused very 
closely on learning how much progress we have made and what 
progress we need to make in the future. I am very interested in 
Mr. Meltzer's recommendation that we need to have an 
independent performance audit or create some type of an entity 
in the World Bank, like the GAO or otherwise, that can perform 
its own audits to give us the kind of information that we need 
in order to maintain this pressure for reform and to understand 
the reforms that we need to implement.
    I know that was not a question. It was more of a statement. 
But, Mr. Chairman, I believe that these are very critical 
issues, and I appreciate you bringing them before us.
    Chairman Shelby. Thank you, Senator Crapo.
    Senator Allard.
    Mr. Taylor. Senator, could I just respond?
    Chairman Shelby. Dr. Taylor, go ahead, if you want to 
respond to him.
    Mr. Taylor. I think if you look at my testimony, I think 
you will find a lot of significant movement in the direction of 
the reforms that the Meltzer Commission and others have 
suggested.
    For example, we do have right now independent audit of our 
new measurable results system at the World Bank. It was just 
approved by the board. So that is a very significant 
development. It is an independent audit of a particular issue.
    We have moved substantially in the direction of grants. 
That was another part of the recommendation of many people, and 
we got international agreement to do that. I just went on a 
trip to Africa to observe how the grants are doing. They are 
very popular. It is a real significant accomplishment.
    Conditionality has been narrowed substantially at the IMF. 
They do not have hundreds of thousands or even thousands or 
hundreds of conditions now. They have narrowed their focus. 
They should narrow it further.
    There has been a lot of progress and a lot of international 
agreement, and I think that should be recognized. It does not 
mean we are done. It does not mean we are not going to go 
forward. Secretary Snow wants us to move ahead more. But let us 
recognize what has been done, sir.
    Senator Crapo. I appreciate that, and I do want to 
understand where we are. And I appreciate the fact that we have 
been moving in the right direction. That will help us to 
determine what we need to take as the next steps.
    Thank you.
    Chairman Shelby. Senator Allard.

               STATEMENT OF SENATOR WAYNE ALLARD

    Senator Allard. Mr. Chairman, I have a statement I would 
like to have made part of the record.
    Chairman Shelby. Without objection.
    Senator Allard. I am particularly interested in the 
difference between IMF's Independent Evaluation Office and the 
World Bank's Operations Evaluation Department. I understand 
that the IEO is much more independent and also seeks more 
outside information and evaluation of the IMF than the OED 
seeks on the World Bank. Would you agree with that 
understanding?
    Mr. Taylor. Both of these entities are just beginning. The 
IEO, from what I have seen so far, is consulting broadly in its 
reviews. It has not done very much yet, has just begun. They 
have a good person in charge. I have spoken to him many times. 
We will have to see. We are watching it closely, but I think it 
is very important that they do thorough evaluations of the 
subjects that they look.
    The OED, basically it is the same idea. We have, as I just 
mentioned a minute ago, asked for some of the things be done by 
an independent audit, and maybe we can do a comparison of the 
independent audit on this issue and the OED. I think that will 
give us some information. Right now I would not say that 
characterization that one is working better than another is 
correct. I think we have to look at how both of them are 
working, and be diligent in making sure they are working well.
    Senator Allard. But the IEO seems to be consulting more out 
and around. Was that your initial statement?
    Mr. Taylor. I have observed myself more consultation with 
the IEO. I cannot say whether they have been more consultative 
than the other group, no.
    Senator Allard. I see. Do you believe that the current 
relationship between the World Bank and the OED is more 
appropriate for ensuring accountability and transparency or 
overseeing such a large financial institution with such a huge 
amount of risk?
    Mr. Taylor. I think the OED is a step in the right 
direction, and as I say, I have spoken to them. We discussed 
their doing this work on the audit rather than have an 
independent audit. We chose the independent audit approach. 
That is something that the Congress requested as well. But my 
sense is the structure here allows for it to do the independent 
reviews and I think we are just going to have to see over time 
whether it needs to be adjusted or not, but I think the 
structure is fine at this point. But again, we have now 
established at least one independent audit of some significant 
things we are asking the World Bank to do, and I would like to 
compare that to what the OED does. That would be very useful.
    Senator Allard. As you can probably tell by now, I am 
particularly interested in accountability and the transparency 
of financial institutions. One of the ways in which 
accountability and transparency can be evidenced is through 
practices like external audits. The GAO recommended in 2001 and 
2003 that independent, external auditors conduct an audit at 
every multilateral development bank each year that would 
evaluate several aspects of bank operations that are not 
covered by the much simpler audits now conducted. For example, 
the GAO noted that the World Bank has several offices that 
function as internal control systems, but that to date there is 
no way to know how effective they are in making sure bank funds 
are used for the assigned purposes, and that bank policies are 
obeyed. Congress agreed and recommended public summaries of 
such independent audits be published annually by June 2005.
    The question is, has Treasury met with the GAO since 
January to review the terms of reference that apply here and to 
plan these audits, and can you share with us your outline for 
that work?
    Mr. Taylor. Our staff has met with GAO regularly, Senator. 
On these particular issues, laying out a timeline, I will have 
to get back to you to see exactly what has been proposed.
    Senator Allard. Can you get back for the record for the 
whole Committee, please?
    Mr. Taylor. Yes, sir.
    Senator Allard. Any further comment?
    Mr. Taylor. I think just maybe a comment would be that 
based on the experience we just had with this independent audit 
initiative at the World Bank--we are one shareholder at the 
World Bank. There are many others. Every reform like this 
requires international consultation at a great degree of 
financial diplomacy if you like. This one was very hard to get 
through, and I think what is going to be important is for us to 
show in practice to our fellow shareholders whether or not this 
improves things. So to me it is a very important thing that we 
have this one example of an independent audit going through, 
and I think if we can show it is useful or if we find a better 
way to do it, then we can develop the international consensus 
that is needed to move the organization in a more productive 
way.
    I just add that to your question, Senator.
    Senator Allard. Mr. Chairman, I have just one other 
question, and if it has been addressed, I apologize, but this 
possible $100 billion from the World Bank that never was 
actually received by recipient countries, apparently that had 
been intercepted and privatized illegally, according to some 
testimony that was before the Senate Foreign Relations 
Committee, where they had held a hearing combatting corruption 
at the multilateral development banks. Apparently this was from 
Professor Jeffrey Winters' research. Has the Department of the 
Treasury come up with any official statement supporting or 
denying those claims? It would be interesting to hear your 
thoughts on those estimates in that matter.
    Mr. Taylor. I believe this came up in a hearing last week 
at Senate Foreign Relations, and our representative at the 
World Bank responded, and if there is more information that you 
needed than that, we will be happy to give it to you, but the 
$100 billion is not something I find at all substantiated at 
this point. We will be happy to look further into it, but it 
does not sound plausible at this point. I will be happy to look 
into it more, Senator.
    Senator Allard. I think we should. This is testimony that 
was given by an individual before the bank, and I would assume 
that the Senate Foreign Relations might be following up on it, 
but it is also something I think is of interest to this 
Committee, certainly of interest to me, because it gets to the 
very issue of accountability of dollars, and we have that 
responsibility as policymakers here to make sure that taxpayer 
dollars when they go to IMF or whatever are handled in a 
responsible way and that things are making sure that we do not 
end up dealing with illegal activity in some way or another. If 
you can share with us in the record at some point in time, make 
it part of the written record here in this Committee, I think 
it would be helpful.
    Mr. Taylor. Would be very happy to. Some of the things that 
we are doing at the World Bank to improve accountability is to 
have a system to measure the results of what they actually do 
with the money, the number of school books, for example, that 
are purchased, or the number of schools that are built or the 
number of inoculations that occur, and it is really improving a 
lot but we have to keep working at it. I very much applaud your 
efforts to help us look into it, Senator.
    Senator Allard. You are talking about a performance-based 
evaluation.
    Mr. Taylor. Yes, sir.
    Senator Allard. I think that is really important. I want to 
see all the agencies in our Government do that, and I certainly 
think that the World Bank needs to do that and I appreciate 
your bringing that up without any of us having to bring it up.
    Chairman Shelby. Senator Sarbanes.

             STATEMENT OF SENATOR PAUL S. SARBANES

    Senator Sarbanes. Thank you very much, Mr. Chairman. I am 
pleased to join with you in welcoming Under Secretary of the 
Treasury John Taylor here this morning.
    Secretary Taylor, I want to show a few charts just to set 
the context of the discussion that I want to have with you. 
This is the U.S. trade deficit beginning back in 1980 and 
coming across this is where we are today. If one thinks that a 
negative trade deficit matters, and I happen to think so, 
particularly when it gets to this order of magnitude, this is a 
chart that is a cause for great concern. I mean this is an 
incredible deterioration in our trade position. The current 
account position gives us that story.
    I have to tell you, I spent a year working for Walter 
Heller, when he was the Chairman of the Council of Economic 
Advisors under President Kennedy, and he used to worry about 
these things. And then we were running positive balances, but 
even then he worried about them. Now we have this incredible 
position here, and this is what has happened to the U.S. net 
international investment position. We have gone from positive, 
and we are down here in a very significant negative posture.
    The first question I want to ask, and I put it very simply, 
does this a change in position worry you?
    Mr. Taylor. Senator, the first thing I would say is that 
the third chart, the net investment position, represents many 
people around the world investing in the United States, equity, 
lending, because it is such a good investment. It is a good 
place to invest.
    Senator Sarbanes. So the situation does not worry you? I 
mean your position, I take it, is they are all happy to take 
our debts so we build up this obligation to everybody, but that 
just shows that they have a lot of confidence in America; is 
that correct?
    Mr. Taylor. It shows that they have a lot of confidence in 
America. The second thing I would say is that comparison to the 
early 1960's, we now have a flexible exchange rate. We are not 
trying to defend the Bretton Woods fixed exchange rate system, 
so that inconsistency or tension is gone. There is much more 
flexibility with respect to financial markets in the world, so 
it is possible to have flows of capital of that magnitude occur 
in ways that would be much more worrisome then. That is not to 
say it is not at all worrisome now. It is not to say that we do 
not need to be concerned with making growth higher elsewhere in 
the world because the number one way to reduce that deficit 
right now is to have other countries be attractive places to 
invest so that the funds can go elsewhere as well.
    That is a major part of what we are trying to do 
internationally is to find ways to increase growth elsewhere 
because that will help the United States and help that problem.
    Japan's economic growth in the last six quarters, for the 
first time in 12 years, is finally showing some signs of 
sustainability. That represents an important accomplishment 
with respect to our international economic policy. Right now, 
there is strong growth of much of Asia, and much of Latin 
America. So that will help that.
    Senator Sarbanes. Can I come back to my question? It does 
not worry you, is that right?
    Mr. Taylor. There is aspects of it that are worrisome and 
that is why we are taking----
    Senator Sarbanes. Former Secretary of the Treasury Summers 
said in a recent speech, ``There is surely something odd about 
the world's greatest power being the world's greatest debtor.'' 
He calls it troubling that the United States depends so much on 
inevitably political entities to finance its foreign debts. 
What do you think of that?
    Mr. Taylor. I do not know what the context of former 
Secretary Sommers' comments are, Senator, but what I do know--
--
    Senator Sarbanes. Do you think it is odd that the world's 
greatest power is the world's greatest debtor?
    Mr. Taylor. I think that what is important is that those 
investments are there because the United States is an 
attractive place to invest.
    Senator Sarbanes. Chairman Greenspan told the Senate 
Banking Committee, this very Committee, that the rate at which 
the United States is running current account deficits is 
unsustainable. He said countries that have gone down this path 
invariably have run into trouble, and so would we. What do you 
think of that?
    Mr. Taylor. Again, I do not know the context of the 
Chairman's statement, but what I do know is that----
    Senator Sarbanes. I think it is in this context that we 
have set here.
    Mr. Taylor. Right now, the efforts to deal with the problem 
are to raise economic growth other parts of the world, but we 
certainly do not want to make the United States a less 
attractive place to invest. Those investment flows create jobs 
in America. They create growth in our productivity and it is a 
very important thing to do. We would like to have more 
investment in the United States, not less investment in the 
United States. We would like to have more savings in the United 
States. But our emphasis here, rather than just to say that 
there is a problem, is to do something about it, and that is 
what we are doing.
    Senator Sarbanes. You are kind of whistling past the 
graveyard, are you not? The IMF, in their World Economic 
Outlook, the most recent report released by the IMF, made 
reference to the deterioration in the U.S. fiscal position. 
Then they go on to say, ``Moreover, today, the external 
position of the United States is weaker, involving record high 
current account deficits and rapidly growing net foreign 
liabilities, and so it is more vulnerable to changes in 
sentiment in exchange rate markets. The prospect of continuing 
large U.S. fiscal and external deficits and the implied 
external borrowing adds to concerns about international 
imbalances, increasing the changes of a disorderly resolution, 
including a rapid fall in the value of the dollar and a rise in 
U.S. long-term interest rates.''
    What is your reaction to that?
    Mr. Taylor. I do not like everything the IMF writes, and 
that is an example which I do not think is very accurate.
    Senator Sarbanes. I see, all right.
    Mr. Taylor. What we are emphasizing here is there is an 
important role for the United States in keeping our own economy 
strong. It is really one of the strongest economies in the 
world right now. We are trying to get other economies to grow 
more rapidly, so that can benefit the United States and create 
less imbalances.
    Maybe what you could do is go further on in those reviews 
to see what they are suggesting. We have suggestions here and 
policies that we are following that are working. They are 
making the United States stronger and they are making the world 
stronger, stronger than it has been for a long time.
    Senator Sarbanes. What is your concern about the burden 
that is being placed on the future generation to pay on these 
claims that foreigners are building up against the United 
States? I mean what this will require is that we will have to 
have an outflow of payments to handle this international debt 
that we are accumulating. Is that not correct?
    Mr. Taylor. Yes. When an investor makes an investment in 
the United States, they expect to get a rate of return. So 
those flows are the rate of returns. If a business invests in a 
foreign business or a foreign individual invests in the United 
States, they expect to get returns.
    Senator Sarbanes. We used to pride ourselves on the fact 
that we built up those investment positions abroad and were 
getting returns. Now it has just turned right around on us, has 
it not?
    Mr. Taylor. What has turned around is the United States is 
one of the most attractive places for people to invest around 
the world. They are making those investments and they are 
getting returns.
    Senator Sarbanes. You think it is being done on a straight 
market basis.
    Mr. Taylor. I have no reason to believe otherwise.
    Senator Sarbanes. You just came back from China and Japan, 
correct?
    Mr. Taylor. Yes, sir.
    Senator Sarbanes. What do you think of the huge public 
decision that is being made in Japan, for example, to put money 
into the American market? I would argue that it helps sustain 
their trade position. Are you at odds with that view?
    Mr. Taylor. The Japanese have not been intervening in the 
market since March 16, sir. There have been no interventions. 
There were no interventions while I was in Japan.
    Senator Sarbanes. What was the magnitude of their 
interventions in the markets?
    Mr. Taylor. It varied from day-to-day, and in 2003 and 
early 2004 it was very large, unprecedented in its magnitude. 
But it since then----
    Senator Sarbanes. I am sorry we do not have Fred Bergsten 
on a panel with you, but I am going to borrow from what he says 
in the----
    Chairman Shelby. Senator Sarbanes, he is coming next.
    Senator Sarbanes. Yes. But I am going to borrow from his 
statement which will come next.

    The immediate issue is the massive intervention in the 
currency markets by China, Japan, Korea, Taiwan, and perhaps a 
couple of other countries to keep their exchange rates from 
rising against the dollar. China's intervention in 2003 
exceeded the total increase in its GDP. Japan's intervention in 
the first quarter of this year exceeded the global total of the 
U.S. current account and budget deficits, that is, the Bank of 
Japan by itself more than financed all of our twin deficits. As 
a result of this intervention, all four countries cited here 
amassed foreign exchange reserves far in excess of any 
conceivable needs they might have--to levels of $850 billion 
for Japan, almost $500 billion for China, $200 billion for 
Taiwan, and $160 billion for Korea.

    Now, what is happening? Here is Japan's stock of foreign 
reserves. Look at that beauty. I mean this is 1999 here and it 
is on a straight upward path, Japan's stock of foreign 
reserves. Here is China's stock of foreign reserves. You are 
the Under Secretary of the Treasury for International Affairs. 
This is China. Look at what is happening to their stock of 
foreign reserves. This is Taiwan. I mean it goes on and on. And 
you are telling me the market is working? This is South Korea. 
Look at that one.
    Now, I have Europe, the market to some extent I think is 
working in Europe.
    Senator Allard. Would the Senator from Maryland yield for a 
question here?
    Senator Sarbanes. Yes. Just let me finish these charts and 
orders. This is the EU stock of foreign reserves. And of 
course, I will not show it because I want to yield to my 
colleague, but I have a chart about where the currencies have 
gone. The EU currencies have adjusted and now you are telling 
me the market is working with Japan, China, Korea, and Taiwan? 
They are working the market. They are working the market. What 
is your response to what they are doing?
    Mr. Taylor. Our response has been articulated in the G-7 
statements on these topics, which is to call for greater 
exchange rate flexibility in countries that do not have such 
flexibility, and those are the ones that you have just held up 
there with the exception of the last one, which is the euro, 
which has had flexibility. So our approach here is 
internationally to ask for additional flexibility in the world 
economy. It is important to get it just for the reason you have 
your charts up there. But I would just make sure that my 
statement about working the markets is there, because we have a 
amazing degree of good flexible markets in the United States. 
The United States is an attractive place to invest. We do not 
depend in any way--our markets are large and resilient. We do 
not depend in any way on the charts that you showed us right 
there. The market is working.
    What we are doing now is emphasizing to all of the 
countries that you have just held up there the importance of 
moving to exchange rate flexibility.
    Senator Sarbanes. What is the key to doing that?
    Mr. Taylor. To moving to flexibility?
    Senator Sarbanes. In the Asian markets. It is the China 
currency, is it not?
    Mr. Taylor. That is a big part of it, yes.
    Senator Sarbanes. Yes. Now, they have it pegged, right?
    Mr. Taylor. Yes, sir.
    Senator Sarbanes. Are you in favor that they go to flexible 
rates?
    Mr. Taylor. Yes, I am.
    Senator Sarbanes. What would that do to their banking 
system in the short-run?
    Mr. Taylor. They would go to a flexible exchange rate in a 
way that would make sure it does not harm their banking sector 
in the short-run or the long-run.
    Senator Sarbanes. My understanding is that most people 
think they just cannot go to flexible rates and what you should 
be seeking is that they repeg the rate at least in order to get 
this into more equilibrium and to allow these other countries, 
Japan, Korea, and Taiwan, which are staying in the wake of the 
Chinese currency because they do not want to disturb their own 
trade relationship with China, to allow adjustments to take 
place in their rate. Would that not be the case?
    Mr. Taylor. I think the best way to do it is to have a 
flexible exchange rate, and that will let the market work even 
more.
    Senator Sarbanes. Meanwhile we are sitting here and getting 
these incredible deterioration of our positions. You apparently 
do not think it matters very much. I mean Greenspan tells us it 
matters. Summers tells us it matters. Bergsten is going to tell 
us that it matters in his testimony coming later this morning. 
I think you are just not coming to grips with the problem in my 
perception.
    Mr. Taylor. I do not think I ever said it does not matter, 
Senator. What I said is what we are doing about it.
    Senator Allard. Senator, would you clarify for me when you 
talk about the stock of foreign reserves, this is money that 
has been put in our banks here in America; is that what that 
is? What is that figure right there?
    Senator Sarbanes. No. These are their holdings.
    Chairman Shelby. Of our stock.
    Senator Allard. These are their holdings of our stock.
    Senator Sarbanes. Yes. They have built up these currency 
reserves, very strong positions. And we owe it. We owe it. They 
are running it right up.
    The Bank of Japan, as I said, Japan's intervention in the 
first quarter of this year exceeded the global total of the 
U.S. current account and budget deficits. That is, the Bank of 
Japan itself more than financed all of our twin deficits. So 
they took these claims against the United States.
    Now, the Secretary is arguing that it reflects confidence 
of investors overseas.
    Chairman Shelby. In the American----
    Senator Sarbanes. My understanding is these are public 
decisions, not private decisions; is that correct?
    Mr. Taylor. Yes, sir.
    Senator Sarbanes. This was a decision by the Bank of Japan, 
the Government, not by private Japanese investors about the 
strength of the American economy. Now, why did the Bank of 
Japan make that decision?
    Mr. Taylor. The Bank of Japan can probably best answer that 
question, Senator.
    Senator Sarbanes. I know, but you are the point person in 
the Government for this. What is going on here?
    Mr. Taylor. The Bank of Japan is----
    Senator Sarbanes. Do you think they made that decision in 
order to sustain the currency position and gain a trade 
advantage from it?
    Mr. Taylor. The Bank of Japan, in the last 6 months or a 
year or so, has improved the liquidity position of the Japanese 
economy in a way that the Japanese economy is now finally 
growing in a sustained way. The sustained way which can 
purchase U.S. goods and U.S. exports. That is the important 
thing to look at. The intervention has stopped. As of March 16, 
it is a figure that does not show up in your chart, so there 
has been none since then.
    And I would say also, Senator, in terms of the overall 
flows of funds into the United States, you can make an 
intervention look big by comparing it to all types of things, 
but what is important is there is huge, gross flows coming into 
the United States, investing in our businesses, investing in 
our economy, and that is a good thing. If there were less 
investment by those countries in securities, I do not think 
that would change that picture much at all. Why they are doing 
it, we have indicated they should not be doing it. We indicated 
to the Chinese they should not be doing it. It is a major part 
of our initiative now with Japan.
    Senator Sarbanes. If it shows that we are strong, why are 
you telling them not to do it? I mean there is an obvious 
contradiction what you just said. You are telling me on the one 
hand, oh, this shows we are strong and they are putting it in, 
that is a good thing, and yet, you are going over there and 
telling them not to do it. You are telling them not to do it. 
Are you telling them that we are going to have a hearing before 
one of these Senate Committees, and someone is going to raise a 
little ruckus about it? Presumably not. Why are you telling 
them not to do it?
    Mr. Taylor. Because it is in the interest of their economy 
and ours to have a more flexible exchange rate. Very simple. It 
does not mean that the United States should be a less 
attractive place to invest. We want to be more attractive to 
invest. We want to have our economy continue to grow. It is 
perfectly consistent. The United States is an attractive place 
to invest. The world would be a better place if there were more 
flexible exchange rates in China. There is no inconsistency 
whatsoever in those two statements.
    Chairman Shelby. Senator Carper.

             STATEMENT OF SENATOR THOMAS R. CARPER

    Senator Carper. Mr. Secretary, could you take a couple of 
minutes and give us a primer, if you will, on the financing of 
our budget deficit, and the financing of our trade deficit? My 
understanding is that our budget deficit for this fiscal year 
will be about $400 billion, and could you just talk a little 
bit about how that is being financed, please?
    Mr. Taylor. It is financed by issuing Treasury securities, 
and the Treasury securities are auctioned and people of all 
sorts buy them. Most are bought by Americans. Some are bought 
by foreigners. Some are bought by foreign governments. So that 
is how it is financed, and it is going very well and works very 
well in the Treasury. The auctions are working just fine, and 
actually the amount of borrowing we have had to do recently is 
lower than what was expected. So that financing is working 
fine.
    With respect to the current account, it is financed by all 
the people around the world who want to invest in the United 
States. They are private individuals and it is not just 
investing in Government securities, it is investing in our 
businesses and investing in real estate, investing in private 
bonds, so there is a wide range of investors in the United 
States just like Americans invest abroad in huge magnitudes. It 
goes both ways. Right now there are more people investing in 
the United States, and Americans are investing elsewhere around 
the world. That is why I was saying to Senator Sarbanes it 
represents the fact the United States' economy is a very 
attractive place for people to invest at this point.
    Senator Carper. Could you give us some idea of the 
magnitude with respect to the financing of our budget deficit, 
and the purchasing of Treasury securities? To what extent--and 
if you can quantify this for us it would be helpful--is the 
budget deficit being financed by individuals or banks within 
this country as compared to the individuals and businesses and 
governments from outside this country?
    Mr. Taylor. I will get you the exact figures for you, 
Senator.
    Senator Carper. Just the rough magnitude.
    Mr. Taylor. It would be about 80 percent domestic private 
individuals at this point in time, and there is a stock issue 
of how much in the past has been invested that way versus each 
month how much different it is, but what I could do is get you 
the statistics for the month or for the years, but that is a 
rough order of magnitude.
    Senator Carper. So we will just say our budget deficit is 
$400 billion this year. Are you suggesting that maybe 20 
percent of that, maybe $80 billion, will be financed from 
people abroad?
    Mr. Taylor. Approximately. I will have to get the exact 
figures for you.
    Senator Carper. Would most of that be by individuals? By 
banks? Would it be by foreign Governments? Do you have any idea 
how that breaks down?
    Mr. Taylor. Most of it at this time would be by foreign 
governments, our own individual securities, yes. In the last, 
say, year or so it would be mostly governments.
    Senator Carper. Just take a minute and explain why we have 
an interest in doing so.
    Mr. Taylor. Because governments tend to hold government 
securities much more than they hold private-sector securities. 
It is the nature of reserves, international reserves are always 
invested in very safe kinds of assets, so they are looking for 
U.S. Government securities the invest in because they are very 
safe. So that is why governments tend to invest in our 
securities in a greater proportion than they invest in private 
securities.
    Senator Carper. In an earlier conversation that I had with 
Chairman Greenspan this year, when he sat in your seat, we 
talked about whether or not we eventually reach a point where 
people, businesses, banks, or Governments in other countries 
decided that they needed a high rate of return on our 
securities in order to continue to invest in those securities. 
Are those fears or concerns misplaced or not?
    Mr. Taylor. I do not think any concern is necessarily 
misplaced. I think if the United States becomes a less-
attractive place to invest, then investment in the United 
States will go down and will go elsewhere. We have no reason to 
think that that would be sudden. The charts that Senator 
Sarbanes presented, showed a steady movement over the years 
starting in the early 1990's. The United States' economy is 
very flexible. The international financial system is working 
very smoothly right now, a lot of orderly movements in the 
markets. There is no reason to think that things should be 
steady. But I do hope that the United States continues to be an 
attractive place to invest because that means our economy is 
working well, and our productivity growth is just astoundingly 
strong right now. The economy is working very well. So that is 
why people want to invest here.
    But if other economies worked better, and I think that is 
the way to thin about it, we would like the rest of the world 
to do better than it is doing, we would like the United States 
to do better, too, creating more jobs, but the thing here is, 
if other economies become attractive places to invest, then you 
reverse some of this asymmetry that you mentioned, the Chairman 
himself mentioned.
    But I think that our approach is to try to have stronger 
growth elsewhere around the world. We have something called the 
Agenda for Growth that the Secretary works through his G-7 
counterparts, and I think that is the way you deal with these 
problems, not to try to make the United States a less-
attractive place to invest, but to emphasize exchange markets 
should be flexible, ask the Chinese to have a more flexible 
exchange rate system, and they are saying they are moving in 
that direction, all of these things, it seems to me fit 
together in terms of a good international policy that is 
working quite well right now.
    Senator Carper. I read in the paper the other day that our 
trade deficit for I guess it was last month was pretty 
substantial. Do you recall what it was?
    Mr. Taylor. I will have to get the exact number for the 
last month, sir, but it is about, it must be about $30 to $32 
billion, I guess. I will have to look it up.
    Senator Sarbanes. What was that figure?
    Mr. Taylor. For the month, it says $46 billion.
    Senator Sarbanes. Trade deficit, $46 billion in the last 
month, was it not?
    Mr. Taylor. Forty-six, yes.
    Senator Sarbanes. Did you say $30 billion?
    Mr. Taylor. I said $36 billion or something like that, yes. 
It is $46 billion.
    Senator Carper. I remember in a year, a whole year, where 
it was not that much, and I am sure you do, too. And if we go 
back to the 1970's, or the 1980's, it was probably $46 billion, 
somewhere along that in a given year. And what it seems to have 
done is to have increased through the 1980's, through the 
1990's, and certainly into this decade. I just do not think we 
can continue to go on buying more from other countries, ever 
more from other countries than they purchase from us. It is 
maybe not a cause of alarm for you, but it is sure a cause of 
concern for me.
    And one of the things that Senator Sarbanes is trying to 
get across is should we not be concerned about this? Should we 
not be doing something about it?
    Mr. Taylor. We are doing something, Senator. And I cannot 
emphasize more that what we are doing is taking action. And 
whether we are more concerned or less concerned than other 
people, I cannot say. I know that we have a responsibility here 
is to put some policies into action, and they are working, and 
they are making a difference for the United States. Our economy 
is growing very strong. The economies in the rest of the world 
are beginning to grow more rapidly. It is working.
    The focus on the trade flows is certainly important to do 
and look at. The current account deficit is certainly something 
to be concerned with, but I cannot measure whether I am more 
concerned or less concerned than anybody else. I know I am 
trying to take some actions working with the Secretary, and I 
think it is working. And I can just go through flexible 
exchange rates, the Agenda for Growth, structural reforms 
around the world. The world economy is in better shape now than 
it has been for a long time, and that shows what we are doing 
is working.
    And you can always look for the bad parts of things and try 
to emphasize those. And as policymakers, we want to look and 
worry about things, and we do, but I think what you do want to 
emphasize here is how strong the United States' economy is, how 
we are creating jobs, how the policies are working, both 
domestically and are working with other countries, and it all 
wraps up to be a good picture. And you are pointing to some 
things that we all need to be concerned about, and we are, and 
we are taking action. That is the important thing is to take 
action.
    Senator Carper. Mr. Chairman, I would just say, in 
conclusion, I am one of those people, Mr. Secretary, who always 
sees the glass as half-full. I am an undying optimist, but I 
must say when I look at the trade deficit, which is $46 billion 
last month and is $552 billion in a year, and, boy, I find it 
hard to feel optimistic about that.
    Thank you.
    Chairman Shelby. Senator Sarbanes.
    Senator Sarbanes. I wanted to just, also, Mr. Chairman, put 
in the record a statement from the Monetary Policy Report to 
the Congress by the Board of Governors of the Federal Reserve 
System in which they note,

    The financing counterpart of the current account deficit 
experienced a sizeable shift in 2003, as net private inflows 
fell while foreign official inflows increased. . . . 
Accordingly, net inflows through private securities 
transactions decreased markedly. In contrast, foreign official 
purchases of U.S. assets surged to record levels in 2003, with 
the accumulation of dollar reserves particularly high in China 
and Japan.

    So this inflow is not coming from private decisionmakers 
judging the U.S. economy. In fact, they are going the other 
direction. It is coming from governmental decisions, and I am 
suggesting very strongly that they are making those 
governmental decisions in order to affect the trade 
relationship.
    Senator Sarbanes. I want to put one question to the 
Secretary on capital controls. I have a very strong concern 
about the Administration's approach in trade negotiations on 
the capital controls issue. It is my understanding that the 
goal of the Administration and the so-called ``transfers 
provisions'' dealing with capital controls in the proposed Free 
Trade Agreement is the absolute right to transfer capital with 
no exceptions, even for short-term portfolio investments in the 
event of a balance of payments crisis.
    When resistance is met, such as was the case in the 
Singapore and Chile agreements, the goal is to craft only the 
narrowest and least-meaningful exception. In my view, this is a 
very shortsighted approach, both as a matter of policy and 
negotiating tactics.
    Since the Asian financial crisis, most mainstream 
economists and financial efforts think that capital controls on 
short-term portfolio investments at least should be an option 
available to countries in the context of a balance of payments 
crisis. It is my understanding that the IMF no longer precludes 
such an option for countries with which it negotiates loan 
agreements.
    I would ask the Administration to reconsider this approach 
on capital controls. Surely, in a balance of payments crisis, 
some exceptions, at least with respect to short-term portfolio 
investments, should be in order.
    Have I accurately reflected the Administration's rigid 
positions on capital controls in the trade agreements? Is that 
the Administration's bargaining position?
    Mr. Taylor. We have two very good Free Trade Agreements 
with Chile and with Singapore. And in those agreements, we 
asked for, and obtained, a great degree of security with 
respect to investments in those countries. One of the concerns 
that foreign investors have when they invest in countries is 
that their capital will be frozen or that we will not be able 
to get it back. So we have been very diligent in negotiating 
trade agreements which preserve the ability to transfer capital 
in and out of countries. It has been a major factor in all of 
our bilateral investment treaties for many years. We do not 
want to change that with our Free Trade Agreements. So we have 
been very insistent that this is a good thing to do.
    The United States does not have such controls, and it is a 
vibrant economy. Many developing countries also do not have 
such controls. In the Central American Free Trade Agreement, 
this issue was not raised.
    But what we did do for both Singapore and Chile is allow 
them to have an extension of the dispute resolution mechanism 
that occurs with respect to all of our agreements. We would 
like investors, again, to invest in a country with the notion 
that they can have their money move around, they can get the 
profits back. That is what our investors would like to do, and 
that is what all foreign investors would like to do. That is 
how these economies are going to thrive if they get to foreign 
investments. So what we have been doing in these agreements is 
emphasizing the importance of the ability of free transfers of 
capital.
    And when the countries, for one reason or another, do not 
want to do that, they have to go through the dispute resolution 
mechanism which is available in our Free Trade Agreements, and 
with respect to portfolio investment, they have a little longer 
period of time before the dispute resolution takes place. It is 
a fine approach, it is working, and the countries are quite 
happy about it.
    Senator Sarbanes. Is it your view that short-term capital 
flows constitute investments in the way you are just using the 
term? I take it, it is.
    Mr. Taylor. Some of them certainly do. It could be a loan 
for inventories.
    Senator Sarbanes. In the NAFTA, there was a balance of 
payments exception included, and covered investments were 
defined so as to exclude debt securities and loans of less than 
3 years original maturity. It seemed at least to address the 
short-term capital flow problem. You object even to that 
limitation; is that correct?
    Mr. Taylor. There is some disagreement about how to 
interpret the North American Free Trade Agreement in this 
regard, Senator. But just to answer your question, I think that 
we should try to have as much ability for investors to move 
capital around. And short-term capital can sometimes be to 
finance inventories for a business. And frequently when 
countries try to limit that, they hurt the small businesses. 
There is evidence that in the capital controls that Chile had 
in the past, which they do not have any more, that it affected 
their small businesses, the worst part of society to hurt. That 
is where the jobs are created and where people come out of 
poverty.
    Our feeling is that the more you could do to have a 
sensible treatment of these kinds of investment, which are 
investments. They are loans. They are helping businesses. 
Whether the maturity is long or short, we should try to 
encourage that, and that is what we do in these agreements, and 
I think they are good agreements.
    Senator Sarbanes. How does China's fixed rate impact this 
issue of short-term capital flows?
    Mr. Taylor. Well, China's fixed rate is something that we 
hope goes away.
    Senator Sarbanes. I understand. But as it works now, how 
does it impact?
    Mr. Taylor. They could have restrictions on capital flows 
whether or not they have a fixed exchange rate. So, directly, 
it does not impact, but one of the ways in which we have moved 
to have China be more willing to move to a flexible exchange 
rate is to have a greater degree of openness with respect to 
investments into China. So, if Americans want to invest in 
China, it is easier to do so, say, our financial sector, it is 
now easier to do so. There is an automobile loan program that 
Americans are able to participate in, but also the Chinese can 
invest out of the country. For example, when a Chinese student 
comes to the United States, they can take more of their funds 
and put more of their money in dollars than they otherwise 
could.
    We are looking for ways to remove some of the capital 
controls. That will help China, and they are trying to find a 
way to do that themselves. It is related to the flexible 
exchange rate in the sense that flexible exchange rates work 
better when there are not so many capital controls. And, in 
fact, one of the problems with fixed exchange rates is that in 
order to get monetary control in the economy, countries have to 
impose these capital controls. So flexible exchange rates 
allows the country, like the United States, to have a more open 
capital system and that is beneficial for any countries that 
choose to go in that direction.
    So one of the reasons, again, to just repeat, for flexible 
exchange rates is that it allows countries to remove some of 
these controls, which generally do damage to the economy than 
help the economy.
    Chairman Shelby. Senator Allard.
    Senator Allard. Mr. Chairman, I am probably the only real 
free-trader here sitting on this panel today, and I just feel 
like I have to say a few things.
    You know, when you look at our trade deficits, and of 
course I do not think Senator Sarbanes' charts tell the whole 
story, but if you look at the Depression, if you look at the 
time in the late 1970's, when we had the misery index, the 
double-digit inflation, double-digit unemployment, and double-
digit interest rates, our trade deficits were low, and they 
were low during the Depression. But what his charts reflect is 
the growth in our economy that has been happening since the 
middle 1980's and continued to grow, and it also reflects that 
we had a small dip in our trade deficit during the late 2000, 
2001, and 2002 just as we were moving out of this recession. It 
was starting at the end of the Clinton Administration and then 
continued on for a short period of time the initial years of 
the Bush Administration.
    But even though some people wanted to characterize it as a 
real severe downturn in our economy, in respect to other times, 
it was relatively modest, and our economy has continued to burn 
along. It has been doing that for a decade-and-a-half, and it 
just reflects the prosperity in this country. Americans are 
doing well, so they have money to spend. It increases demand on 
the dollar. So we see our dollar goes up. The dollar is like 
any commodity. It is like corn or wheat or anything else, and I 
do not share a concern. If somebody wants to hoard the dollar, 
if they want to somehow or the other manipulate the value of 
the dollar, I think eventually the commodity, looking at the 
dollar, will overwhelm them, and they are hurting their own 
economies in the long-run.
    Now, short term, they may be able to gain some advantage, 
but in the long-run, and I look at what happens to our economy 
in relation to other countries. Our economy has been relatively 
stable. We have had our adjustments, which I happen to think 
are good, but other countries, if you look at what their 
economies will do, real exaggerated upturns and downturns. And 
I think we are doing things in here, and I hope that in trying 
to somehow or the other push trade restrictions, that we do not 
forget the lessons that we learned at the turn of the 20th 
century when we had such high tariffs and so many trade 
restrictions, that our economy struggled in the 1900's to 2000 
and even after that.
    I believe we have a very good economy, and our economic 
policy is working well, and I just think that needs to be said.
    Chairman Shelby. I think a lot of things are working well, 
but we do have some concerns. Let us talk about the current 
account for just a minute. Senator Sarbanes brought it up. 
Chairman Greenspan, who comes to this Committee a lot, he has 
deep concerns about the current account. Tell me, Dr. Taylor, 
what are the big ingredients in our current account today, in 
other words the deficit there. A lot of it has to be oil, the 
importation of oil. I would like to know what percentage or 
roughly what percentage of our $500-billion deficit in the 
current account is made up of the importation of oil and gas 
petroleum products and what is manufactured goods. Can you do 
that for the record?
    Mr. Taylor. I will submit for the record the precise number 
of months, and years, et cetera. But imports of oil are a 
significant thing. That is why it is important to----
    Chairman Shelby. Is it the majority?
    Mr. Taylor. No.
    Chairman Shelby. It is not the majority of our----
    Mr. Taylor. Imports.
    Chairman Shelby. --making up our $500-billion deficit in 
the current account.
    Mr. Taylor. Well, the oil imports you want to measure 
relative to all of our other imports, and it certainly is not a 
majority of all of our other imports, which are many times 
the----
    Chairman Shelby. Is oil the number one single thing?
    Mr. Taylor. I will have to look it up.
    Chairman Shelby. You do not know.
    Mr. Taylor. I do not know. I guess it depends on whether 
you look at crude. If it is certainly just crude, I would 
imagine there are some other. Manufacturers, as a class, would 
probably be larger than just crude oil. So I think we should 
look at the whole table.
    Chairman Shelby. Now, you are----
    Mr. Taylor. You want to look at automobiles versus all 
manufacturers.
    Chairman Shelby. You are a well-known economist now. You 
are not telling us today, are you, that our current account, as 
it is continuing, if it continues at $500 billion a year in 
deficit, in arrears, that that is good for the United States of 
America. You are not saying that, are you?
    Mr. Taylor. No.
    Chairman Shelby. Does that concern you? It certainly 
concerns Chairman Greenspan. It certainly concerns a lot of us 
and others in the company.
    Mr. Taylor. As I indicated, the fact that we are trying to 
do something about it I think shows the concern, and what I 
would always like to do is when people mention their concern is 
to try to say what are you going to do about it? And I am just 
trying to emphasize here what we are doing about it. We are not 
trying to restrict trade into the United States. We are not 
trying to be protectionist. We are trying to encourage other 
countries to grow more rapidly, to take changes so that they 
are also attractive places to invest.
    We are trying to find ways that our saving rate is higher 
because basically then Americans could invest more in the 
United States, as well as foreigners. That would reduce the gap 
between investment and savings. We are doing a lot of things 
that addresses the problem. And in that sense, you could say we 
are concerned.
    Again, I do not know if I am more concerned or less 
concerned than other people. I have issues here that we are 
trying to address. I always try to emphasize what can you do 
about something rather than just say you are concerned. And 
what we are doing about it is the kind of things I have tried 
to list, and what we are not doing are the things I do not 
think we should be doing.
    Chairman Shelby. Doctor, are you concerned at all with the 
manipulation of the Japanese currency by the government that 
has gone on a long time and also the pegging of the Chinese 
currency at what we all consider less than value?
    Mr. Taylor. Yes. That is why we have made such an effort to 
call for increased flexibility.
    Chairman Shelby. What does that do for the Chinese and 
Japanese and what harm does it do to us when they intervene 
like that?
    Mr. Taylor. We have emphasized the flexibility of exchange 
rate because we think that is best for the United States. That 
way we can have a strong-growing economy. Chairman Greenspan 
and the Federal Reserve can concentrate on keeping the recovery 
strong and inflation low. Fiscal policy can be addressed to a 
strong economy of the United States. That is why the flexible 
exchange rate is so valuable for us, and that is why we 
emphasize it.
    But if other countries are trying to peg their currencies 
to the dollar, especially if they are large countries like 
China and Japan, then that is a problem. So what we are doing 
is trying to emphasize this exchange rate flexibility, and I 
believe you are seeing flexibility, certainly seeing 
flexibility with respect to Europe.
    Chairman Shelby. Now, you are not telling us you have seen 
flexibility in the Japanese and Chinese, have you?
    Mr. Taylor. I have seen no flexibility with respect to 
China whatsoever, yes.
    So, I think that is the approach we are taking, Mr. 
Chairman. And I cannot emphasize enough it seems to us that it 
is working because the U.S. economy is strong and, yes, we are 
concerned about the degree to which large countries fix their 
exchange rates.
    Chairman Shelby. I have a number of questions. I am going 
to submit them for the record because we have got another 
panel, but one has to do with China. Why is China the World 
Bank's largest borrower, considering everything?
    The other one--and we will do specifics for you, Doctor--
the IMF's lending portfolio is heavily concentrated among three 
specific countries: Turkey, Brazil, and Argentina. Together, 
they account for approximately 70 percent of the IMF's 
portfolio exposure. Those are concerns to some of us, 
considering the credit risk.
    Does the IMF have any role in the resolution of the large 
stocks of unpayable debt, particularly in crisis situations? 
Are there ways that creditors can be made to negotiate as a 
bloc or should the countries simply announce what it will pay 
and so forth. These are concerns for me, and I will get those 
to you, for the record.
    Mr. Taylor. I would be happy to.
    Chairman Shelby. We appreciate your appearance here this 
morning, and we know this is a difficult and very arcane 
situation, but very important.
    Thank you very much, Dr. Taylor.
    Mr. Taylor. Thank you.
    Chairman Shelby. We are going to call up our second panel, 
if we can at this time.
    Our second panel is Dr. Allan Meltzer, Professor of 
Political Economy, Carnegie Mellon University; Dr. C. Fred 
Bergsten, Director of the Institute for International 
Economics; and Dr. Douglas Holtz-Eakin, Director, Congressional 
Budget Office.
    All of your written testimony will be made part of the 
record of the hearing in its entirety.
    Dr. Meltzer, we will start with you.

                 STATEMENT OF ALLAN H. MELTZER

          THE ALLAN H. MELTZER UNIVERSITY PROFESSOR OF

         POLITICAL ECONOMY, CARNEGIE MELLON UNIVERSITY

                      AND VISITING SCHOLAR

                 AMERICAN ENTERPRISE INSTITUTE

    Mr. Meltzer. Thank you, Mr. Chairman. I have to apologize. 
I have to leave at 12:30.
    Chairman Shelby. That is okay. We will try to get you out 
before then. We might submit some questions for the record.
    Mr. Meltzer. Thank you. I will be glad to answer them.
    It is a pleasure to appear, yet again, before this 
Committee and to review the progress of international financial 
institutions. Today, I will briefly review IMF and World Bank 
programs to assess what has been done, what more needs to be 
done to make the world economy less risky and less prone to 
crises and to improve living standards in the poorest 
countries. These are big topics. I will limit my formal remarks 
to major changes that have occurred, or that should occur for 
these institutions to become more effective in realizing their 
objectives. I will discuss the IMF and the World Bank in that 
order.
    Much of what the charters of the IMF and the World Bank say 
about purposes and objectives is out of date. The current 
mandate of the IMF should be to reduce global risk to an 
obtainable minimum. The current mandate of the World Bank 
should be to facilitate social and economic development as a 
means of reducing poverty.
    How can the IMF reduce risk to an obtainable minimum? The 
IMF has two principal functions that can improve the markets' 
operations in ordinary times and in crises. One is to increase 
the quantity and quality of the information that the market 
has, and two, the IMF can do a significant job in trying to get 
that information and improve the quality and the timeliness.
    Under pressure from the critics, the IMF has made much more 
information available about its activities, recommendations, 
and assessments. Important as is the improvement of 
information, the most important function of the IMF is to 
reduce the risk of severe crises that spread internationally. 
Improved information contributes, but reform of IMF procedures 
is important also.
    Prodded by its critics and its new management over the last 
3 years, the IMF improved its operations and recommendations in 
several ways that Dr. Taylor described.
    It now restricts the conditions attached to loans to a 
small number of macroeconomic and financial measures or 
objectives. It appears less willing to make massive loans than 
in the 1990's, and it pays more attention to avoiding crises 
and the determinant of debt sustainability in developing 
countries.
    The most important single change remains undone. The IMF 
should move from its command and control approach to one that 
relies on incentives. Historically, the IMF has attached 
conditions to its loans. The country agrees to the conditions 
to get the loan, but may be politically unpopular at home to 
enforce conditions such as expenditure reduction or tax 
increases or growth may be less than anticipated, requiring 
additional partial adjustment.
    The IMF's Independent Evaluation Office found that 
countries achieved about one-half of the proposed change in 
fiscal balance, on average. About 60 percent of the programs 
underperform. This command and control approach has the 
unfortunate side effect of making the IMF appear responsible 
for imposing harsh measures under adverse circumstances. The 
country's government, of course, agrees as a condition of the 
loan. This does not remove the IMF's responsibility in the 
minds of the country's electorate, the protestors at 
international meetings, and much of the public.
    I believe that a reform occurs when the country's leaders, 
a majority of its citizens or both want reform. Reform cannot 
be imposed successfully and has not been imposed successfully 
by external technocrats without local support. Local 
governments can, and do, frustrate reforms or ignore IMF or 
World Bank conditions. The reason Turkey, Brazil, Argentina, 
Ecuador, and others have repeated crises is that they do not 
reform enough to avoid them. They promise, but they do not 
reform. Command and control fails, as we should expect it will.
    The main reform needed at the IMF is the development of an 
incentive system to replace command and control. Briefly, the 
IMF should establish a short list of policies or observable 
standards that countries should adopt to be assured of 
assistance in a crisis. It should use its surveillance to 
assure that a country meets the standards and publish the list 
of countries that do, and do not, get a guarantee of crisis 
assistance. The IMF would not help countries that do not meet 
the standard. To prevent crises from spreading, the IMF would 
assist countries that are victims of crises of neighbors or 
trading partners.
    Countries that adopt the standard would be subject to less 
risk. Hence, they could borrow more capital at a lower interest 
rate spread over U.S. Treasuries. Other countries would get 
less capital and pay a higher interest rate. This would give 
the government and the public considerable incentives to adopt 
stabilizing policies. The capital markets, not the IMF, would 
impose discipline.
    The IMF itself is at risk. As my colleague, Adam Lerrick, 
has shown, that risk is a cost to the United States and other 
countries, but does not appear in our budget. Lerrick estimates 
the hidden annual cost of the IMF to U.S. taxpayers currently 
is $1.5 to $2 billion. The principal component is the risk of 
default by one of the major debtors; four countries--Argentina, 
Brazil, Indonesia, and Turkey--owe about 70 percent of the 
IMF's outstanding debt. The IMF avoids default by lending more 
money or, as in the case of Argentina, by extending the 
maturity of existing debt. As in the past, the IMF will come 
eventually to the Congress for a quota increase, either because 
of a default or because its resources are allocated to unpaid 
loans.
    Reform of the system should be a priority. The 
Administration, to its credit, has made considerable progress 
getting collective action clauses into private debt contracts. 
Reform of debt repayment to international financial 
institutions and to lenders should be next on the agenda.
    In the past few years, the Administration and the Congress 
have insisted on some of the reforms advocated by the majority 
report of the International Financial Institution Advisory 
Commission. Monitored grants replaced some of the lending to 
the poorest countries. The Administration has worked to set 
explicit conditions that can be monitored and has introduced 
incentives for countries to meet those conditions. In its most 
recent budget, Congress required an independent performance 
audit of some IDA programs and insisted on greater transparency 
at the World Bank. These steps are a good start, but only a 
start.
    The central issue about the World Bank, with its many 
programs, is it spends or lends about $20 billion a year, but 
neither we, nor they, know which programs are effective and 
warrant expansion or retention and which are ineffective, and 
inefficient and should be abandoned.
    The monitoring the Congress insisted upon for part of IDA 
should be extended to the entire bank and its facilities. We 
should know what is effective and what is not, where the money 
goes, and how it is used to improve the lot of the poor. There 
are two ways to gain the needed information: One is an 
independent performance audit by an outside agency. Another is 
development of an independent internal group similar to the GAO 
or the IMF's Independent Evaluation Office. The current 
arrangement at the Bank does not meet this standard. An example 
will bring out the problem.
    We have considerable evidence that poverty has declined 
dramatically by the number of people living on a dollar per day 
or less in the world. The decline is most striking in Asia, 
especially in China and India. Market opening, private 
investment, protection of property rights, and the like 
contributed much to the improvement. Where these spurs to 
growth and development are largely absent, as in sub-Saharan 
Africa, poverty has increased. Did World Bank programs 
contribute to the reduction of poverty in Asia? Did these 
programs ameliorate worsening prospects in Africa? The Congress 
should want answers to these questions.
    Further, the Bank should concentrate on the hard cases, the 
impoverished countries. The Banks should have an explicit 
program for graduation. Countries like China that can borrow in 
the capital markets with investment-grade ratings should not 
receive subsidized loans. Those loans can be better used to 
provide potable water, sanitary sewers, disease control in the 
poorest countries and would encourage countries to adopt 
institutional reforms that have been effective in spurring 
development. These include the rule of law, open trading 
arrangements and protection of property rights and individual 
rights.
    Finally, we should insist that the IMF and the Bank 
eliminate overlapping responsibilities. The World Bank should 
become a more effective development Bank. The Bank has 
estimated that a trillion dollars a year is paid in bribes to 
all countries. A large part is in the developing countries. 
Ridding the system of corruption is a major challenge.
    The IMF's responsibility should remain the maintenance of 
global financial stability. As a result of experience in the 
Asian crisis, many Asian countries have accumulated substantial 
reserves to protect them against crises and to avoid being put 
under IMF supervision. They have also established a regional 
lending system outside the IMF. This, too, opens important 
questions about the future role of the IMF, particularly the 
role of the IMF in Asia. New leadership in the IMF and the end 
of James Wolfensohn's term at the Bank in 2005 provides an 
opportunity for new leadership, new approaches, and much needed 
reform.
    Thank you, sir.
    Chairman Shelby. Dr. Bergsten.

                 STATEMENT OF C. FRED BERGSTEN

        DIRECTOR, INSTITUTE FOR INTERNATIONAL ECONOMICS

    Mr. Bergsten. Mr. Chairman, I would like to pick up from 
where Senator Sarbanes and you were having your discussion with 
Under Secretary Taylor a moment ago and just elaborate a few of 
the points that were focused there.
    There is absolutely no doubt why the East Asian countries 
have been buying huge amounts of dollars. They have been doing 
so to keep their exchange rates undervalued to strengthen their 
trade competitive position as part of their own economic or 
development policies. They do not think of it as investments. 
They think of it as job creation. They keep the price of their 
currency low. That keeps the prices of their products low. That 
improves their market shares in world trade, and that adds to 
their economic development.
    The impact on us is to preclude the necessary adjustment of 
our own exchange rate to reduce our own unsustainable trade and 
current account deficits, as you outlined, and that of course 
hurts our economy and reduces job creation in our own economy. 
It is that simple.
    Senator Carper asked a very good question to Under 
Secretary Taylor: Well, why is it that the Japanese Government 
is buying U.S. Government paper? It is not as if the Japanese 
Government has to look around for investments. The Japanese 
Government is running a huge deficit--7 or 8 percent of their 
GDP. They are issuing huge amounts of paper themselves. The 
last thing in their mind is having financial assets that they 
have to look around to find a place to put. They are, in fact, 
taking huge amounts of money that they have to borrow from 
their own people in order to put them into Treasuries to keep 
the prices of their currency undervalued to strengthen their 
trade and competitive position. In other words, it is even 
worse than was being said before.
    The two big concerns: Japan and China. Senator Sarbanes 
picked up that line from my testimony which is just so stunning 
as to be worth repeating. In the first quarter of this year, 
Japan bought over $150 billion of U.S. dollars in the exchange 
markets and put the money in Treasuries. That is one quarter--
multiplied by four, $600 billion annual rate. That is more than 
our entire budget deficit. It is more than our entire trade and 
current account deficit. So the Government of Japan, all by its 
little self, was doing this in order to protect its own 
competitive position and maintain its position in world trade.
    Chairman Shelby. Doctor, what can we do about it?
    Mr. Bergsten. That was the final point, and I will just 
jump straight to it.
    Under Secretary Taylor said, and is of course right, that 
we want other countries to grow faster, and that is helpful, 
but the truth is the fastest, conceivable growth rate, from all 
of the other countries he is talking about--the Japanese, the 
Europeans, et cetera--would have a very marginal impact in 
reducing our trade deficit. We have run the equations. Every 1 
percentage point of faster world growth takes something like 
$10 billion a year off our trade and current account deficit. 
It helps, but it is tiny.
    There is only one possible way to get our trade deficit 
down substantially within any reasonable period of time, and 
that is a lower exchange rate for the dollar. I am not calling 
for a weak dollar. The dollar rose in value by a trade-weighted 
average of 40 percent from the minimum in 1995 to early 2002. 
It produced a hugely overvalued dollar in the exchange markets; 
overvalued in the sense that our underlying competitive 
position cannot support the value of the dollar with that 
currency.
    Over the 2 years, from early 2002 to early this year, the 
dollar came down by a trade-weighted average of about 10 
percent--moving in the right direction. Incidently, it did so 
in a totally gradual and orderly way, no disruption to our own 
markets, the world economy, et cetera, but it only came down 
about a third to a half what is needed to restore any semblance 
of sustainability in our current account position over time.
    I have sympathy for Under Secretary Taylor because I used 
to be in his job. He cannot sit here and say, like I just said, 
we need a lower exchange rate for the dollar. He did say we 
need more flexible exchange rates, by which he means the yen, 
the Chinese renminbi, and others need to go up against the 
dollar; for example, we need a lower exchange rate for the 
dollar. That is what he is saying.
    The issue is have he and his colleagues done anything 
effectively to get it there, and there my answer is no; that 
both the Treasury and the IMF--and I document this in my 
statement--have failed to carry out the obligations of law, in 
the U.S. case, of the IMF statutes, in the IMF's case, to take 
significant action to bring those other currencies down. 
Indeed, the Chinese, by pegging to the dollar, have actually 
ridden the dollar down over the last 2 years, become more 
competitive, had a trade-weighted depreciation of their 
currency of 8 percent, making the world's most competitive 
economy even more competitive.
    Now, what can you do about it? You can bring lots of 
diplomatic and economic pressure. The United States has done it 
in previous episodes when we have had to play rough. But I had 
a simple suggestion for the Treasury Department a year ago when 
the Japanese intervention was at its height. I said you should 
simply call up the Japanese and tell them that for every dollar 
they buy in the exchange markets, you are going to sell a 
dollar. You are going to counter their movement in the exchange 
markets, which is so obviously counterproductive, to us, to 
them, I would argue in the long-run, and to the world economy. 
And, indeed, you would never even have to do it because, if you 
told them you were going to do it, they would cease and desist.
    I was in Tokyo all last week. Under Secretary Taylor said 
the Japanese have not intervened for the last 2 months, and he 
is factually right. I was in Japan all last week. I talked to 
the officials that are most directly involved. I asked him if 
we could be assured that they had now ceased their intervention 
forever, and of course the answer was no. So, if the yen starts 
to rise again, and they become unhappy with the level to which 
it rises, you can be sure they will intervene again.
    So we are going to have to take some serious action. I 
believe if we did the kind of suggestion that I indicated, that 
it would be enough to deter future action, but until we get 
serious and undertake action, not just words, the problem is 
going to continue.
    Thank you.
    Chairman Shelby. Doctor, what would be the repercussions if 
we told them, and we have to mean what we say, ``You buy. We 
are going to sell?''
    Mr. Bergsten. Well, the markets would then realize that 
their intervention would be ineffective. The markets would 
therefore take the exchange rates to levels that the markets 
thought were right, which would be a considerably stronger 
exchange rate level----
    Chairman Shelby. Well, that is what we want, is it not?
    Mr. Bergsten. And that is exactly what we want, and that 
would be the objective of the exercise. Secretary Taylor is 
right, conceptually, that we want these currencies where the 
markets would take them.
    Chairman Shelby. But how do you get there? Because we are 
no progress, are we?
    Mr. Bergsten. Exactly.
    Mr. Meltzer. May I comment?
    Mr. Bergsten. So my suggestion, while seeming to some to be 
playing hard ball, would I think be both effective and 
unnecessary to actually implement because the threat would be 
so severe.
    Chairman Shelby. Dr. Meltzer.
    Mr. Meltzer. There is an element missing in this discussion 
that is really quite critical, and that is, if a country has a 
fixed exchange rate, and its currency is truly undervalued, 
then it gets a big capital inflow, as China does, and that 
inflow produces either pressure to change the exchange rate or 
inflation. What matters is not the nominal exchange rate, the 
8.25 renminbi to the dollar. What matters is the real exchange 
rate adjusted for prices. Now, prices are starting to rise in 
China. That is a step in the direction of desirable changes.
    The Chinese do not like inflation. That, more than any kind 
of pressure that the United States can put on them, is going to 
push them to do something about the problem that they see, 
which is to avoid the inflation and avoid the further 
depreciation or undervaluation of their real exchange rate. But 
it is the real exchange rate that matters, and countries can 
only control it for a certain length of time without running 
into problems of inflation or deflation. The Chinese have come 
from deflation, to modest inflation, and they headed toward 
higher inflation, and they understand that, and they need to do 
something.
    Second, I would say it is a problem, as Members of the 
Committee have said, about the Chinese banking system. But the 
Chinese banking system could easily be improved by the huge 
stock of foreign exchange reserves that the Chinese have 
accumulated. They have the wherewithal to bail out the bad 
loans of their banking system, and that would be a step toward 
greater flexibility, and that is a pressure that the 
Administration should try to put on them, that is, to fix their 
banking system with the dollars that they have accumulated and 
then go on to a more flexible exchange----
    Chairman Shelby. Doctor, can they every really fix it, as 
long as they have state-owned industries, making bad loans to 
failing----
    Mr. Meltzer. That is correct. They cannot permanently fix 
it because they use the banking system as really to do the 
fiscal policy operations of the government and to provide 
employment in the losing sectors of the economy, mainly the 
state-owned industries.
    Chairman Shelby. Dr. Bergsten.
    Mr. Bergsten. Can I just say I fully agree with both of Dr. 
Meltzer's points, and I do agree that the rise of inflation and 
overheating of the Chinese economy, and further urgency from 
their standpoint to the desirability of the one-shot 
revaluation of the currency. Dr. Meltzer is right. They will 
wind up taking it one way or the other. But from their 
standpoint, it would be far more desirable to move the exchange 
rate preemptively rather than to let inflation and overheating 
build up. They could then suffer a hard landing of their 
economy, which would be bad for all of us. That is further 
reason why they should take the exchange rate action now.
    Chairman Shelby. Doctor, we appreciate your patience.

                STATEMENT OF DOUGLAS HOLTZ-EAKIN

             DIRECTOR, CONGRESSIONAL BUDGET OFFICE

    Mr. Holtz-Eakin. Well, it is a long way from this 
fascinating discussion to the arcana of the budget, but let me 
spend a couple of minutes summarizing the main points of the 
testimony that we submitted.
    Chairman Shelby. Yes, sir.
    Mr. Holtz-Eakin. As the Chairman is well aware, the 
multilateral financial institutions have an important function 
in international financial markets, mainly to enhance the flow 
of credit to borrowing countries to meet policy objectives. And 
in this way, they are similar to many domestic programs of the 
Federal Government, such as direct student loans, student loan 
guarantees, Federal guarantees of mortgages, and a variety of 
other programs that the Congress has undertaken.
    In my remarks today, I want to really focus on a few 
points:
    As with those domestic programs corresponding to these 
policy objectives, there are costs, and unlike the domestic 
programs, the multilateral financial institutions operate as a 
collective effort. We have other nations involved in providing 
this policy objective, and they operate in an institutional 
setting that is quite different from domestic settings, making 
it more difficult to trace those costs back to the portion that 
resides in the United States.
    Finally, they also operate in a world that has changed 
greatly. Recent developments in both international financial 
markets and the operation of these institutions make history 
less of a guide for those costs in the future.
    In 1990, the Congress, in the Federal Credit Reform Act, 
sought to place domestic credit operations on a more even 
footing, from a budgetary point of view, taking things such as 
direct student loans, where there was a clear cash outflow, and 
guarantees, where there was no apparent cost, and trying to 
turn them into the equivalent of grants in each case--asking 
how much, in the way of economic resources, were being 
provided.
    And with a decade of experience, a little bit more, the 
House Budget Committee has asked the House CBO to revisit the 
Credit Reform Act, and we are in the process of looking at a 
variety of activities: The provision of guarantees through 
things such as the Air Transportation Stabilization Board and 
the provision of pension guarantees through the PBGC; we also 
have some work in which we are looking at improving mortgage 
guarantees. And much like those activities, the activities of 
the multilateral financial institutions at their core involve 
an economic subsidy.
    In the testimony, we lay out a ballpark calculation that 
suggests that relative to market borrowing. In 2003, the three 
multilateral financial institutions--the two windows of the 
World Bank and the IMF--provided economic subsidies that could 
be as large as $20 billion to the borrowers involved.
    Now, we know that the United States really is responsible 
for only a portion of that subsidized lending. It may be the 
case that not all of the subsidy resides with the MFI's. It may 
be taken up by other lenders. It may be the case that the MFI's 
never pass back a demand for those resources to the Federal 
budget. However, the goal of the exercise in which we are 
engaged is to revisit the nature of these subsidies and look at 
them in the context of financial markets that are now 
characterized by large and much more rapid international 
capital flows, rising importance of private-sector bondholders 
as lenders in the international markets, and relatively 
diminished bilateral lending between two governments.
    It is also the case that there have been some shifts in the 
legal and institutional setting for international workouts. And 
in that context, and with a broader desire by Congress and 
other settings to do forward-looking budgeting for costs that 
may be anticipated, we are undertaking our study. We have some 
preliminary results, which attempt to evaluate the magnitude of 
these subsidies, to assess the links between these subsidies 
and the Federal budget, and to clarify the decisions that face 
Congress in issues and timing between the occurrence of the 
economic subsidies and the budgeting for them and when Congress 
wishes to treat them on the budget.
    We look forward to working with this Committee, and with 
the Congress in general, to provide the budgetary treatment 
that will most illuminate the proper economic and budgetary 
incentives for the Congress.
    Thank you.
    Chairman Shelby. Thank all of you. I have a few questions.
    Dr. Meltzer, are we looking at a potential insolvency 
crisis among developing countries? And why do you believe 
developing countries rely so heavily on short-term funding, and 
what are the obstacles to a market for long-term developing 
country debt?
    Mr. Meltzer. Let me start with the last one. We now have a 
lot of evidence on economic development, and China is a 
wonderful example, but India is also a wonderful example of 
recent progress, and we know what it takes to get long-term 
private capital into those countries.
    It requires some kind of reasonable stability in 
application of the rule of law, where China is somewhat 
deficient, but moving in the right direction. It requires 
openness to trade. It requires some reasonable standards in the 
country for the protection of property rights, and human rights 
would be desirable, although often absent. Those are missing in 
many of these countries, and so they are left to borrow mostly 
in the short-term market, and a lot of their borrowing is from 
international financial institutions, especially among the 
poorest countries.
    Is there a problem of a default to the international 
financial institutions? Unfortunately, the countries do not 
default to the international financial institutions because the 
international financial institutions do not let them. They lend 
them more money to pay the arrears on their debt, and they keep 
financing additionally by sending them more money.
    There is something called the HIPC initiative to forgive 
some of those debts, but that is just a way of recognizing that 
they were not going to be paid.
    Chairman Shelby. Let me ask you this, Dr. Meltzer. In your 
testimony, you state that the IMF should not lend to countries 
that do not meet minimal standards.
    Mr. Meltzer. That is correct. That was the main 
recommendation of a majority of the Commission.
    Chairman Shelby. Some of us are concerned that if the IMF 
said it would not lend to such countries, and then did so, the 
IMF would lose what little credibility it had left. How do you 
make such a commitment credible? Should exceptions be made for 
countries that would present a systemic risk to the 
international financial system? How do you work it? How do you 
balance it?
    Mr. Meltzer. We want to group countries into three groups: 
Those that establish some reasonable standards of prudent 
financial behavior and some other conditions; second, those 
that do not; and, third, those that are at risk because of the 
imprudent countries or perhaps the prudent countries, but 
mainly the imprudent countries, we want to help the first and 
the third group; that is, we do not want international global 
instability. So we are going to say we may have a country--
Uruguay was a good example. It was hurt by developments in 
Argentina and, to a lesser extent, Brazil. The IMF came in, and 
it lent to Uruguay, and substantial amounts to Uruguay, 
relative to the size of its country. We think that is an 
appropriate thing for the IMF to do because it prevents the 
crisis from spreading to third countries.
    We do not think it should be lending money to the countries 
like Argentina that do not meet those standards because, I 
believe--and I think there is good reason to believe--that if 
we told Argentina or Turkey that unless you develop these 
standards, you will not get more aid, there will be pressure in 
those countries to develop more standards because they will be 
able to get more capital at lower interest rates, and that will 
be in their interest, and they will be willing to make the 
changes that are necessary. They have no incentive.
    Turkey has been in trouble periodically since the 1950's, 
and it knows that its friend, the United States, working 
through the IMF, will help it out in each one of those crises, 
so there is no reason to make substantial reforms. It now is 
making reforms. Why is it making those reforms? Not because of 
the IMF--because it wants to join the European Union, so it has 
an incentive to make the reforms that it has not made for the 
past 40 years.
    Chairman Shelby. Dr. Holtz-Eakin, we are aware of CBO's 
ongoing study concerning the economic cost of long-term U.S. 
Federal Government obligations. In Dr. Meltzer's written 
testimony this morning, he cites that his colleague, Professor 
Adam Lerrick, estimates the hidden annual cost of the IMF to 
U.S. taxpayers currently as being $1.5 to $2 billion--I assume 
that is annually--the principal component being the risk of 
default by one of the major debtor countries.
    How does this figure compare to the estimates arrived at in 
your current study? Are those numbers different, yours from Dr. 
Meltzer's?
    Mr. Holtz-Eakin. Well, ours are not yet complete, and I 
will stipulate that at the outset. But I will say that the 
Lerrick calculation is similar in concept to the starting point 
of our investigation, which is a comparison of the market's 
evaluation--what would you charge a risky borrower--with the 
terms actually charged in loans to these borrowers.
    We choose not to look at the difference in interest rates, 
but rather look at the value of the loan versus a bond floated 
on private markets, which looks over the life of the loan. That 
is, the starting point of our investigation is exactly the same 
in character.
    The issues that remain, from our point of view in tracing 
it back to budgetary treatment, are the degree to which those 
loans from, say, the IMF or the World Bank, remains, to some 
extent, senior to those of other lenders thus, more insulated, 
and then the degree to which they will, as a result, come back 
to the U.S. budget.
    Chairman Shelby. In your written testimony, you indicate 
that MFI's may not have enough resources to cover loan losses; 
that is, that the MFI's have a negative net worth. Can you give 
us some sense, this morning, of what the range of the size of 
what that negative net worth would be, what time frame should 
the magnitude of these losses play out, and what would the 
magnitude of the U.S. commitment to cover the negative net 
worth of these in this--what would be----
    Mr. Holtz-Eakin. The numbers in the testimony looked at the 
portfolios of the IMF and then the two windows of the World 
Bank and pointed out the market value was about $203 billion 
below the book value. So that represents the losses on those 
portfolios. That is negative net worth from those entities 
viewed in isolation.
    The share of the United States in those entities is 
difficult to pin down, but as it says in the testimony, we are 
somewhere between 15 and 20 percent for the group.
    And the period over which that might play out is unknown, 
but if one were to go back to the beginning and cumulate all 
such losses, those are the kinds of calculations one would do.
    Chairman Shelby. You noted, at the beginning of your 
testimony, that the current budgetary treatment for 
multilateral financial institutions may fall short of the goal 
of recognizing the magnitude of U.S. commitments to the various 
multilateral financial institutions in a consistent fashion.
    Based on the current treatment, could you elaborate on the 
examples of situations where Congress would have the incentive 
to pursue a particular policy response solely for budgetary 
purposes, rather than because it was the most effective policy.
    Mr. Holtz-Eakin. If you look back to the Credit Reform Act, 
an analogy I think is useful. Prior to Credit Reform, if the 
Government made a student loan, the entire value of the loan 
flowed out. To the extent that there was full repayment, it 
eventually flowed back in. It was entirely cashflow. If it 
guaranteed the exact same loan and got the exact same money to 
a student, it did not show up in the budget.
    As a result, the idea was to make sure that Congress was 
well aware that these were equivalent economic transactions by 
turning them both into the cash equivalent grant to that 
student in terms of a subsidy.
    In the international setting, you can imagine trying to get 
a particular loan amount in new dollars to a borrowing country. 
If done through a USAID loan, it would get Credit Reform 
treatment, and the value of the subsidy would appear in the 
budget. If it were done through the IDA, the Congress would 
have to provide the full budget authority for the loan, similar 
to the method for the original student loans. And if it were 
done through the IMF, there would not be a budgetary entry, but 
instead it would show up as a means of financing. As a result, 
the question is whether those differential treatments would 
lead Congress to misapprehend the relative costs of those 
different activities.
    Chairman Shelby. Dr. Meltzer, I think we know Dr. 
Bergsten's position regarding the revaluation of the Chinese 
currency. I would like your views as to the merits of the 
United States using its persuasive powers versus the strategy 
that you hinted at for using our influence to get the Chinese 
to shore up their financial system more quickly in order to 
facilitate a flexible exchange rate policy. In other words, 
what do we really get by just moving to another peg rate?
    Mr. Meltzer. I think that first we want to look at the 
problem, Senator, from the standpoint not of what is in the 
United States' interest but what is in the joint interest of 
the United States and China but certainly what is in the 
interest of China.
    Chairman Shelby. They are acting in the interest of China. 
Most nations will act in their best interest, will they not?
    Mr. Meltzer. That is right. Now their best interest is 
changing because of the threat of inflation. We can help them, 
as Secretary Taylor said, with technical assistance, that is, 
by trying to show them how to shore up their banking system, 
how to get to a position. But we want to think about this 
problem somewhat more broadly. One of the problems that arises 
in the question of whether there will be a big revaluation of 
the Chinese currency or not is tied to the question of what the 
Chinese do with their internal controls on capital. The Chinese 
savers get virtually nothing for their savings, and they save a 
lot of money. If they opened that up, they would probably want 
to diversify. That would tend to weaken the currency, not 
strengthen it.
    So if we think about the package, and yet it is in the 
long-term interest of us and the Chinese to see a more open 
capital market and a capital market that----
    Chairman Shelby. It would also have political repercussions 
because it weakens the central government, does it not?
    Mr. Meltzer. Yes, it does, and it is probably the main 
reason----
    Chairman Shelby. Because people have choices, do they not?
    Mr. Meltzer. Absolutely. And the control of finance is 
probably one of the major stumbling blocks on which the 
Communist Party is going to not want to give up control. But it 
is certainly in our interest, for that reason probably 
paramount, to see them do that.
    Now, under the treaty under which they entered the WTO, 
they have to do something next year to admit foreign banks and 
give them more opportunity. And that is going to be a very 
important step in dealing with the whole package of issues that 
we have on the financial side with China. So the short answer 
to your question is I prefer to see a floating rate. But I 
prefer to see the floating rate under conditions with freer 
capital movements in China because I think that is a step in 
the direction that we want, geopolitically, China to take.
    Chairman Shelby. But as their economy or the part of their 
economy that is driven by market forces in a sense, and trade, 
as it continues to grow, there will be more pressure 
economically on the government, would it not, to reform the 
banking system for the economy?
    Mr. Meltzer. Yes. But, of course, as you know surely better 
than I, pressures here and pressures there are not on the same 
order, are not on the same scale; that is, we have a lot more 
effective ways of bringing pressure on our Government than the 
Chinese do. And allocating capital is an area which is 
fundamental to the control of the Chinese. That is a big part 
of this issue.
    We would like to see, ideally, much greater freedom of 
capital movements as well as much greater freedom of the 
exchange rate.
    Chairman Shelby. Capital will find its best investment.
    Mr. Meltzer. That is correct, and not be under the control 
of the state.
    Chairman Shelby. By a political entity.
    Doctor.
    Mr. Bergsten. I would just add one point, an implication of 
something that Dr. Meltzer said and I addressed in my written 
statement, but it is important enough to flag orally. I argued 
in my statement that floating the Chinese currency and 
eliminating their capital controls are very good things as 
long-run objectives. But it will take quite a long time to get 
there given the weakness of the banking system and other 
problems.
    Dr. Meltzer made the correct point that if the Chinese did 
eliminate their capital controls and go to a floating rate now, 
their currency might actually weaken in value because a lot of 
the money that is piled up in China as a result of their rapid 
growth and high saving right might go abroad in a one-time 
portfolio reallocation. That would make the trade problem 
worse.
    If a lot of capital went out of China, weakened their 
currency, that would make them even more competitive and make 
the trade problem here an even greater one.
    So that is a further reason why I believe the 
Administration is completely incorrect, as well as impractical, 
in seeking China to float the exchange rate now as their remedy 
to the problem. Do the one-time revaluation now, move toward 
floating and elimination of capital controls, but only over the 
longer-run.
    Mr. Meltzer. May I add one other thing, Senator?
    Chairman Shelby. Yes, Dr. Meltzer.
    Mr. Meltzer. One can get overly concerned about the trade 
deficit, and I think there are people who are overly concerned 
about the trade deficit. I do not believe it is a completely 
innocuous problem and that we should not pay any attention to 
it.
    On the other hand, let us remember----
    Chairman Shelby. Do you consider it a serious problem but 
maybe not a crisis?
    Mr. Meltzer. That is correct. Remember that people are 
selling us goods and services that are valuable, that keep down 
costs of production in the United States, that help us to grow 
and so on. And in exchange, they are taking pieces of paper 
that we can print up at fairly rapid rates and have found means 
to do that. They are earning 1 to 2 percent on those pieces of 
paper. Our firms are earning substantially more on the benefits 
that they get from being able to rationalize their production 
around the world.
    Now, that has short-term costs to us that we all know in 
terms of job creation and factories moving, but it is not an 
action which is wholly harmful to us or that we should regard 
as a crisis that we need to do something about now.
    Chairman Shelby. But, Doctor, you cannot ignore long-term 
implications and long-term obligations and layer after layer of 
a current deficit year after year, though, can you?
    Mr. Meltzer. No, we cannot. But let us recognize that there 
are two parts of this problem: How we got here, how we got from 
$150 billion annual trade deficit to $500 billion. We got there 
because of the committee to bail out the world. Was that a 
mistake? No, it was not a mistake. Now we are here with $500 
billion, and we run into a lot of mercantilists, that is, 
countries that want to push out their exports to sell us goods 
and services more cheaply and take our paper for it. And that 
is a very hard adjustment, and that is not going to be easy, 
but it is not a crisis for us.
    If it continued for a long period of time and our 
productivity growth slowed, it would be a problem, a bigger 
problem than it is now. At the moment the problem comes from 
the thing that Dr. Bergsten has talked about.
    What I worry about is how much of our foreign deficit is 
financed by governments and how much is financed by voluntary 
savings of people who want to invest here. I think we are 
moving from 2003, where it was of the kind that was harmful, to 
2004, where it is more likely to be less harmful.
    Chairman Shelby. Sure. Dr. Bergsten, the last word.
    Mr. Bergsten. I can only characterize what Dr. Meltzer said 
as it is fun while it lasts.
    Chairman Shelby. But it will not last forever.
    Mr. Bergsten. But it will not last that long, and we know 
that from history. The dollar goes into a crash mode about once 
a decade. It has done so for the last 30 or 40 years. When it 
does so, the costs are very high. Even in the build-up period, 
the costs are very high. And, look, I think we all share that 
view here, that something much more effective has to be done 
about it.
    Chairman Shelby. An austerity program could----
    Mr. Meltzer. Senator, every morning I get up, I genuflect 
and pray that I do not have to forecast long-term values of 
exchange rates.
    Chairman Shelby. Thank you.
    I want to thank all of you for your patience and your 
contribution here today, and I am sure we will have you back 
here.
    Senator Hagel is tied up in another Committee, but he asked 
that his full statement and some questions for the record be 
made part of the record. So, I hope you will respond.
    Chairman Shelby. The hearing is adjourned.
    [Whereupon, at 12:09 p.m., the hearing was adjourned.]
    [Prepared statements and additional material supplied for 
the record follow:]
               PREPARED STATEMENT OF SENATOR WAYNE ALLARD
     Thank you Chairman Shelby for convening this oversight hearing on 
the International Monetary Fund and the World Bank. The International 
Monetary Fund works toward a number of different goals through its 184 
member countries which are integral in promoting international 
financial stability. Since it's creation in 1944, the mission of the 
World Bank has evolved from assisting with post-war reconstruction and 
development to fighting poverty and improving the living standards of 
people in the developing world today. Together, the World Bank and the 
International Monetary Fund have an important mission to assist in the 
economic well-being of all nations and provide stability to the 
international financial system.
     As the Members of this Committee know, I always take great concern 
that strict and effective accountability and oversight of financial and 
other institutions are of the highest priority. I played an active role 
in seeing the creation of an Inspector General at the Export-Import 
Bank, and believe that new position has greatly added to the overall 
efficacy and fulfillment of their purpose and mission. I am 
particularly interested in exploring similar issues with specific 
regard to accountability and transparency of operations at the World 
Bank and the International Monetary Fund in today's discussion.
     I would like to thank each of our witnesses for agreeing to 
testify before the Committee today. I look forward to your testimony.
                               ----------

               PREPARED STATEMENT OF SENATOR CHUCK HAGEL

    The Unted States has a significant stake in the International 
Monetary Fund (IMF) and the multilateral development banks (MDB's). 
Over the last 60 years, the United States has appropriated over $45.4 
billion to all the MDB's and authorized an additional $69 billion in 
callable debt. Over that same period, the United States has also 
authorized a line of credit with the IMF that now totals $45 billion. 
The smooth and transparent operation of these institutions is critical 
not only to foreign nations and international investors but also to the 
American taxpayer.
    The Mexican financial crisis of the early 1990's and the Asian 
financial crisis of the mid 1990's highlighted the need for IMF reform. 
In 1998, Congress increased the U.S. line of credit with the IMF by $18 
billion, but before doing so, it mandated a series of reforms. The goal 
of these reforms was to have the IMF better anticipate, prevent, and 
resolve sovereign financial crises. We need to ask: Has this goal been 
achieved or is more reform necessary?
    Earlier this year, I chaired a hearing at the Subcommittee on 
International Trade and Finance which examined the Argentine financial 
crisis. The hearing underscored the increasing number of private 
creditors today that invest in developing countries. In the case of 
Argentina, encouraging the capital flow of private investment is 
essential to ensuring Argentina's long-term economic growth. The 
Argentina crisis demands that we look at the IMF's role in protecting 
private investment when a foreign government defaults on its 
obligations.
    Today's hearing will also look at issues surrounding the World 
Bank. Last week, the Senate Foreign Relations Committee, of which I am 
also a Member, looked at how MDB's are combating corruption. Here, too, 
Congress has a responsibility to ensure that American taxpayer dollars 
are spent responsibly and to examine whether reforms are necessary.
    Investors from around the world look to the United States for 
leadership in institutions like the IMF and the World Bank. It is 
critical that we address reform when it is necessary and promote the 
right policies. America's economic security and prosperity cannot be 
separated from our leadership of the global economy. Thank you, Mr. 
Chairman. I look forward to hearing from today's witnesses.

                               ----------

                  PREPARED STATEMENT OF JOHN B. TAYLOR
               Under Secretary for International Affairs
                    U.S. Department of the Treasury
                              May 19, 2004

    Chairman Shelby, Senator Sarbanes, other Members of the Committee, 
thank you very much for inviting me to discuss the Administration's 
reform agenda at the International Monetary Fund and the World Bank. 
Reform of these institutions--founded 60 years ago at the now famous 
Bretton Woods Conference--has been a high priority since the start of 
the Bush Administration.
    During the first year of the Administration we presented our reform 
agenda for the next few years. President Bush put forth key proposals 
in an important speech at the World Bank in the summer of 2001 just 
before going to his first G-8 Economic Summit. Then, in testimony 
before Congress, in speeches at universities, think tanks, and in the 
financial community,\1\ we discussed the technical details and the 
economic and political rationale for the reforms. We worked together 
with our fellow shareholders and with the staffs of the Bretton Woods 
Institutions. The importance of the reforms was stressed in statements 
by the Secretary of the Treasury at the IMF/World Bank meetings, by the 
U.S. Executive Directors at the Board meetings, and by our 
representatives at the replenishment negotiations of the multilateral 
development banks. A path-breaking international agreement on reform 
implementation was put forth in the form of a G-7 Action Plan in April 
2002.
---------------------------------------------------------------------------
    \1\ Examples include testimony before the Joint Economic Committee, 
February 4, 2002, a speech at Harvard on November 29, 2001, a speech 
before the Bankers Association for Finance and Trade on February 7, 
2002, and most recently a speech at the IMF on April 16, from which 
this testimony draws.
---------------------------------------------------------------------------
    I am happy to report that an enormous amount of rapid progress on 
this reform agenda has been made, especially in the last year and a 
half. The key reforms that have been implemented are:

 collective action clauses in external sovereign bonds;
 creation of clear limits and criteria for exceptional 
    borrowing from the IMF;
 use of grants in partial replacement of loans from the World 
    Bank;
 introduction of a system for measuring results at the World 
    Bank;
 a focus on core expertise at the IMF and World Bank with 
    division of labor.

    As is true of many reform movements, people have discussed and 
recommended such reforms for years. The work of the Senate Banking 
Committee has added greatly to the discussion and debate. But in the 
last few years, we have gone well beyond discussion and debate. What is 
different now is that the reforms have actually been adopted. Taken as 
a whole and assuming they are locked-in, internalized, and expanded as 
described here, these reforms, in my view, represent a fundamental 
policy shift for the international financial institutions.
Goals, the Evolution of Markets, and the Rationale for Reform
    Simply put, the goals of the international financial institutions 
are (1) to increase economic and financial stability and (2) to raise 
economic growth, thereby reducing poverty. These are good goals. There 
is no reason to change them. But the world economy and financial 
markets in which the institutions operate has changed dramatically 
since they were founded, and to achieve these same goals the 
institutions must reform. Consider some of the changes in the world's 
financial markets in just the past 15 years.
    One important change is that securities represent a much bigger 
percentage of cross-border financial flows than in earlier years when 
bank loans were a larger percentage. An important implication of this 
change is that restructuring sovereign bonds--with literally hundreds 
of thousands of bondholders in many different countries--is perceived 
to be more difficult and uncertain than when debt was in the form of 
bank loans by a few banks or syndicates.
    A second change is the increase in the volume of private capital 
flows. Private debt and equity flows grew to be much larger than 
official lending from the international financial institutions. Cross-
border transfer payments are now predominantly private with remittances 
alone much larger than transfers of resources from the international 
financial institutions and other aid agencies.
    A third change is that financial markets are more interconnected 
than in the past, which is one of the reasons for the concerns about 
contagion. The cross-border capital flows seemed to be more volatile as 
well.
    I believe that these changes in the cross-border environment led 
the emerging markets to become more crisis-prone. In fact, both the 
number and severity of financial market crises increased in the 1990's 
compared with the 1980's. By the late 1990's, the emerging markets were 
perceived by investors as so crisis-prone that net private capital 
flows to emerging markets as a whole fell sharply.
    The initial responses to these crises by the official community in 
the 1990's were understandable. As in the case of Mexico, the responses 
had to be developed from scratch in a very short period of time, and 
they had to be implemented immediately. In a number of cases, and in 
the Mexican case in particular, some argued that there should have been 
no special response by the international community, or that the 
response was wrong. But the point I would emphasize is that these 
crises were providing clearer and clearer evidence that the systemic 
changes in the world's financial markets required systematic changes in 
the policy framework underlying the international financial system.
    However, the responses of the international community to crises in 
the 1990's continued in roughly the same fashion as the response to 
Mexico. They tended to concentrate on short term tactics rather than 
strategy. They were designed around 
discretionary changes in the policy instruments rather than systematic 
changes in the policy regime. They tended to be government-focused 
rather than market-focused, emphasizing large loans by the official 
sector and later government-induced bail-ins by the private sector. 
Many observers became concerned that the increasing use of very large 
financial packages and the bail-ins were having adverse effects on 
expectations or incentives.
    A related problem was that loans from the official sector--
including from the IMF and the World Bank--to the very poor developing 
countries in Latin America, Africa, and Asia were building up to 
clearly unsustainable levels. This led to understandable calls for debt 
relief. Again the responses, in my view, were more tactical than 
strategic. They dealt with the current serious need for debt relief, 
but not with the expectations effects and the incentive problems that 
would continue to cause the international institutions to lend too much 
and the poor countries to borrow too much, leading to future debt 
sustainability problems.
    In sum, something important was missing from the international 
financial policy framework, namely more predictability, more 
accountability, and more systematic behavior on the part of the 
official sector. More focus needed to be placed on what public sector 
actions were likely to be in a given circumstance, on what 
accountability there would be for those actions, and on what the 
strategy and the principles behind the actions were.
Collective Action Clauses
    The very essence of these new clauses is to provide greater 
predictability and order to the resolution of sovereign debt. They do 
this by providing a new option for sovereigns to restructure their debt 
without having to obtain the unanimous consent of bondholders. Seventy-
five percent has become the new threshold for amending key payment 
terms in sovereign bonds. I emphasize that the aim is not to make 
restructurings more desirable, but rather to make them more predictable 
and less vulnerable to ``holdouts'' in cases when a country has no real 
alternative. In the absence of such clauses, fears and uncertainties 
about what would happen if a country had to begin a restructuring of 
its debt can interfere with effective decisionmaking, especially in a 
charged political environment. Such clauses are a decentralized, 
market-based approach with a minimum of direction or discretion by the 
official sector. In this way too, the clauses reduce the uncertainty 
that accompanies a nonsustainable debt situation.
    Importantly, the clauses also help the official sector to be more 
credible about the both the likelihood and likely size of its own 
response, and this in turn has favorable effects on market 
expectations, which can reduce the need for large responses by the 
official sector.
    The Bush Administration has actively promoted these clauses. After 
intensive legal and economic research at the U.S. Treasury in late 2001 
and early 2002, we concluded that these were the most promising and 
feasible way to introduce more predictability into the system. The 
official sector facilitated the development of proposals, but we 
emphasized that the market should work out the details and, ultimately, 
choose what language to adopt for the clauses. The clauses then became 
part of the April 2002 G-7 Action Plan.
    We are very pleased with the dramatic progress that has been made 
in implementing these proposals in a very short period. Mexico included 
clauses for the first time in its New York law-governed bonds just 
about a year ago. And now clauses are well on their way to becoming 
standard in internationally issued sovereign bonds. A range of 
countries, including the early clause-issuers Mexico, Brazil, Korea, 
South Africa, and Turkey, have demonstrated that including these 
clauses in their issues has had no adverse impact on pricing. Just 
since January, the Philippines, Panama, Colombia, Costa Rica, 
Indonesia, and Israel have all included these clauses for the first 
time in their New York-issued bonds. Work continues to educate 
potential issuers about the benefits of these clauses, as we advance 
this important trend in strengthening market practices. The new clauses 
are now the market standard in New York.
    Some argue that these clauses do not solve all the problems about 
the uncertainty surrounding debt restructurings, and they are right. 
Future crises may not be as closely associated with debt problems as 
past crises have been. But the clauses and the debate surrounding them 
last year have helped to change perceptions about emerging market debt. 
The debt is now being held by a more diverse class of investors as an 
important part of their portfolios. Moreover, I believe that because 
the reform was implemented so successfully it has bolstered confidence 
in the reform process. People see that financial reform is possible 
even if it is very complex and involves changes in the policies for 
scores of countries and thousands of lawyers, 
advisers, investors, and financial institutions. For example, private 
creditors and borrowing countries now are working on a code of conduct, 
which could add more predictability and order into the system.
Clarifying Limits and Criteria for Large-Scale Official Sector Lending
    There are several components of this reform.
    First is the presumption--based on recent practice since the 
resolution of the Turkish financial crises of 2000-2001 and in 
particular the assistance package of early 2001--that the IMF rather 
than the official creditor governments is responsible for providing 
large scale loan financing. This provides an overall budget constraint 
and thereby an overall limit on loan assistance, recognizing that IMF 
resources are limited.
    Second, within the context of this overall limit there has been an 
endeavor by IMF shareholders and management to signal in advance of a 
decision not to provide additional IMF loans when it appears that the 
limits of sustainability may be reached in the near future. Signaling 
policy changes in advance--even in broad outline--can lead to smoother 
adjustments and provide investors with time to obtain information about 
fundamentals. This reduces greatly the chances of contagion, because 
surprise increases or decreases in official financing can lead to runs 
for the exits and sudden stops. Also part of the principle of limiting 
funding when countries continue to follow unsustainable policies is to 
assist countries that are following good policies but may be hit by a 
crisis in the nearby country that is not following good policies. This 
too will help to reduce contagion in the event that the near-crisis 
country does in fact go into financial crisis. The clearest example of 
this is the case of Argentina where additional IMF resources were not 
suddenly stopped in 2001, but rather continued with signals--including 
restructuring funds built into the August 2001 program--that additional 
funding in the face of the ongoing debt sustainability problem would 
not continue. In addition, a financial assistance package was provided 
to Uruguay--which had been following good policies--to deal with the 
monetary crisis brought on by the bank runs of its close neighbor in 
2002.
    The third component of this reform adds specificity and 
accountability to the first two components. This is the agreement by 
the IMF Board in 2002 and 2003 on four specific criteria that should be 
met before large scale lending above certain limits can take place. The 
criteria are (1) balance of payments pressures on capital 
account, (2) high probability of debt sustainability, (3) good 
prospects of regaining access to private markets so that IMF financing 
provides a bridge, and (4) good economic policies in place. In 
addition, the IMF Board has adopted as a standard that, in cases of 
exceptional access, a new exceptional access report be prepared by the 
IMF management and published. The aim of the exceptional access report 
is to provide accountability in the same way that monetary policy 
reports or inflation reports provide some accountability at central 
banks.
    Because these criteria must be interpreted in each case, it is 
clear that the limits themselves are not rigid. The reality of the 
market and policy environment is that the IMF management and the IMF 
member governments should use the criteria judiciously rather than 
rigidly. One cannot plan for all contingencies and so the criteria are 
closer to policy principles or guidelines. Nevertheless, the specific 
criteria represent a marked change in the direction of a more 
systematic and predictable policy regime.
    The purpose is to reduce the uncertainty and the perverse 
disincentives in the markets due to lack of clarity about how much 
funding will be provided from the IMF and under what circumstances. The 
clearer limits help define the policy regime under which market 
participants and borrowing countries can operate. As part of the policy 
framework defined by the clearer access limits, the general presumption 
is that the official sector will avoid arm-twisting the private sector 
to do bail-ins, because this can lead to uncertainty about future 
applications and encourage early runs for the exits.
    With these criteria in place, the question is frequently asked 
about how they were applied last year in the cases of Argentina and 
Brazil. In both of these cases, however, the countries were already in 
exceptional access territory and the goal is to exit from this 
exceptional access over time. The Argentina program is now focused on a 
complex debt restructuring. And a goal of the Brazil program is to exit 
from the exceptional access.
Grants Rather Than Loans to Very Poor Countries
    Providing more grants to heavily indebted poor countries (HIPC) is 
necessary to deal with their long-run debt sustainability problems. 
Debt forgiveness through the HIPC process in a way that deals with 
their debts to the international financial institutions is essential 
for the countries with unsustainable debt situations. But if the 
international financial institutions return to their heavy emphasis on 
lending, then there are perverse incentives for these countries to get 
into an unsustainable situation again, which will lead to the debt 
relief cycle all over again.
    This is more than a simple financial issue. Unsustainable sovereign 
debt not only requires a government to use new resources for repayment 
of such debt, but it also reduces private sector investment needed for 
economic growth and poverty reduction. Using grants rather than loans, 
therefore, avoids leading these countries down the path of heavy 
indebtedness.
    Of course, this is a fundamental and difficult reform. Since their 
founding 60 years ago, the managements and shareholders of the Bretton 
Woods Institutions have thought of them primarily as lending 
institutions. Nevertheless, remarkably good progress has been made in 
implementing this reform. In 2002, an international agreement was 
reached to use up to 21 percent of the World Banks' International 
Development Association (IDA) window for grants. This allows 
substantially larger percentages in the heavily indebted IDA countries.
    The grants have proved very popular in the countries that have 
received them thus far, but work needs to be done to further increase 
grant funding for the very poorest and heavily indebted countries and 
to integrate this more systematically into the debt relief process.
Measurable Results Systems with Accountability and Incentives
    Another change in the world economy since the founding of the 
Bretton Woods Institutions is the mainstreaming of modern management 
techniques into private firms and the public sector. Effectiveness at 
these institutions requires that they also adopt such changes, 
including managing for results with clear accountability and 
incentives. Good progress has been made at the World Bank during 2003 
in establishing a measurable results system for outcomes in countries 
as part of the new ``measurable results incentive program'' established 
in 2002 in the last replenishment IDA-13.
    Nevertheless, there is a need to expand to more outcome indicators 
in the next replenishment IDA-14 and have more shareholders use such 
approaches. There is also a need to develop better systems for 
measuring outputs at the project level and include measurable outputs 
with timelines in loan/grant documents and in country assistance 
strategies for Board approval. There is also a need to develop a 
similar approach at the IMF.
Focus IMF and World Bank on Core Responsibilities Allowing for
Division of Labor
    The core responsibilities of the IMF are monetary policy, fiscal 
policy, financial markets, and exchange rates. Many IMF employees 
comparative advantage is in these highly technical areas. Focusing on 
these core issues makes IMF surveillance and crisis prevention more 
effective. In contrast, the World Bank's core responsibilities are 
structural policies that raise productivity growth, such as 
infrastructure, business climate, education, health, and governance.
    As part of the focus on the core responsibilities the IMF should 
concentrate its programs on a small number of core issues and leave the 
other issues to the World Bank, thereby creating a useful division of 
labor. Good progress is being made here too, but many programs, 
especially in very poor countries, still have IMF structural conditions 
that should be left to the World Bank.
Strategic Review and New Directions
    I think it is clear from this brief review that progress has been 
substantial. But it is also clear that more work can be done to lock-in 
and expand the reforms. Now seems to be an opportune time to move 
ahead. First, the recent progress has generated a new enthusiasm and 
momentum for reform--a positive feeling that by working together, the 
international community can make progress in fundamentally reforming 
the international institutions, a goal that has been on people's minds 
since their 50th anniversary. Second, we are currently in a period not 
preoccupied with an immediate and emerging financial crisis, which 
gives the relevant participants time to consider longer-term reforms. 
And, third, there is the occasion of the 60th anniversary.
    For these reasons, Secretary John Snow, as this year's Chairman of 
the Group of 7 Finance Ministers and Central Bank Governors, has called 
for strategic review with the aim of defining new directions that build 
on recent reforms and, if necessary, expand them. There has already 
been a very positive response to Secretary Snow's initiative from 
developed countries, emerging market countries, and developing 
countries. Broad consultation is under way, so it is still too early to 
tell what the new directions will be, but some examples of ideas that 
have already been well received are:

 A new nonborrowing program facility at the IMF with emphasis 
    on strong country ownership in program design.
 A new surveillance system including a reorganization that 
    ensures that debt sustainability analysis and other vulnerability 
    analyses relevant to IMF lending is pursued independently from IMF 
    lending decisions, publication of all IMF country reports, explicit 
    allowance and encouragement of country-led development and 
    presentation of policies for IMF assessment, and explicit focus on 
    contagion by looking at connections between countries and assisting 
    countries with good policies that are hit by crises in other 
    countries.
 A further increase in the amount of grants going to poor 
    countries from the World Bank and the other multilateral 
    development banks in conjunction with additional debt relief in 
    order to further improve debt sustainability, economic growth, and 
    poverty reduction.
Conclusion
    The reforms I have discussed in this testimony are technical, and 
may seem arcane to some. But they are deeply important for world 
economic growth and stability--the goal of the international financial 
institutions.
    Thanks to the very successful implementation of reforms during the 
past 2 years as well as actual improvements in economic stability and 
growth in the world economy, I believe there is a willingness to 
consider further reform and to spend the time needed to get the 
technical details right as Secretary Snow has urged in his G-7 
``strategic review and new directions'' initiative.

                               ----------

                 PREPARED STATEMENT OF ALLAN H. MELTZER
               The Allan H. Meltzer University Professor
            of Political Economy, Carnegie Mellon University
          and Visiting Scholar, American Enterprise Institute
                              May 19, 2004

    Mr. Chairman and distinguished Members of the Senate Banking 
Committee. It is a pleasure to appear before you once again to review 
progress in reform of international financial institutions. Today, I 
will briefly review IMF and World Bank programs to assess what has been 
done, what more needs to be done to make the world economy less risky 
and less prone to crises, and to improve living standards in the 
poorest countries. These are big topics. I will limit my formal remarks 
to major changes that have occurred, or that should occur for these 
institutions to become more effective at realizing their objectives. I 
will discuss the IMF and the World Bank in that order.
    Much of what the charters of the IMF and the World Bank say about 
purposes and objectives is out of date. The current mandate of the IMF 
should be to reduce global risk to an attainable minimum. The mandate 
of the World Bank should be to facilitate social and economic 
development as a means of reducing poverty.
    How can the IMF reduce risk to an attainable minimum? The IMF has 
two principal functions that can improve the market's operations in 
ordinary times and in crises. One function is to increase the quantity 
and improve the quality of information available to private lenders. 
The other function is to reduce the risk of financial crises in a given 
country and the spread of crises to other countries, as in Latin 
America in the 1980's and Asia in the 1990's.
    Under pressure from its critics, the IMF has made much more 
information available about its activities, recommendations, and 
assessments. This information can be used by private lenders to improve 
their assessment of risks in a given country. This is particularly 
important for making judgments in the ordinary course of lending. Many 
problems in developing economies arise or are exacerbated by the volume 
of short-term renewable loans used to finance risky, longer-term 
assets. Timely release of information about a country's debt structure 
and performance can reduce this type of lending.
    Important as is the improvement of information, the most important 
function of the IMF is to reduce the risk of severe crises that spread 
internationally. Improved information contributes, but reform of IMF 
procedures is important also. Prodded by its critics and its new 
management over the last 3 years, the IMF improved its operations and 
recommendations in several ways. It now restricts the conditions 
attached to its loans to a small number of macroeconomic and financial 
measures or objectives. It appears less willing to make massive loans 
than in the 1990's. And it pays more attention to avoiding crises and 
to determinants of debt sustainability in developing countries.
    The most important single change remains undone. The IMF should 
move from its ``command and control'' approach to one that relies on 
incentives.
    Historically, the IMF has attached conditions to its loans. The 
country agrees to the conditions to get the loan, but it may be 
politically unpopular at home to enforce conditions such as expenditure 
reduction or tax increases. Or, growth may be less than anticipated, 
requiring additional painful adjustment. The IMF's Independent 
Evaluation Office found that countries achieved about one-half of the 
proposed change in fiscal balance on average. About 60 percent of the 
programs underperformed.\1\
---------------------------------------------------------------------------
    \1\ ``Fiscal Adjustment in IMF-Supported Programs,'' Independent 
Evaluation Office, IMF, September 2003, 7-8.
---------------------------------------------------------------------------
    This command and control approach has the unfortunate side effect 
of making the IMF appear responsible for imposing harsh measures under 
adverse circumstances. The country's government, of course, agrees as a 
condition of the loan. This does not remove the IMF's responsibility in 
the minds of the country's electorate, the protestors at international 
meetings, and much of the public.
    I believe that reform occurs when the country's leaders, a majority 
of its citizens, or both, want reform. Reform cannot be imposed 
successfully by external technocrats without local support. Local 
governments can, and do, frustrate reforms or ignore IMF (or World 
Bank) conditions. The reason Turkey, Brazil, Argentina, Ecuador, and 
others have repeated crises is that they do not reform enough to avoid 
them. They promise, but they do not reform. Command and control fails, 
as we expect it would.
    The main reform needed at the IMF is development of an incentive 
system to replace command and control. Briefly, the IMF should 
establish a short list of policies or observable standards that 
countries should adopt to be assured of assistance in a crisis. It 
should use its surveillance to assure that a country meets the 
standards and publish the list of countries that do--and do not--get a 
guarantee of crisis assistance. The IMF would not help countries that 
do not meet the standard. To prevent crises from spreading, the IMF 
would assist countries that are victims of crises in their neighbors or 
trading partners.
    Countries that adopt the standard would be subject to less risk. 
Hence, they could borrow more capital at a lower interest rate spread 
over U.S. Treasuries. Other countries would get less capital and pay a 
higher interest rate. This would give the government and the public 
considerable incentive to adopt stabilizing policies. The capital 
markets, not the IMF, would impose discipline.
    The IMF itself is at risk. As my colleague Adam Lerrick has shown, 
that risk is a cost to the United States (and other countries) but does 
not appear in our budget. Lerrick estimates the hidden annual cost of 
the IMF to U.S. taxpayers currently as $1.5 to $2 billion. The 
principal component is the risk of default by one of the major debtors.
    Four countries--Argentina, Brazil, Indonesia, and Turkey--owe about 
70 percent of the IMF's outstanding debt. The IMF avoids default by 
lending more money or, as in the case of Argentina, by extending the 
maturity of the debt. As in the past, the IMF will come eventually to 
the Congress for a quota increase either because of a default or 
because its resources are allocated to unpaid loans.
    Reform of this system should be a priority. The Administration, to 
its credit, has made considerable progress in getting collective action 
clauses into private debt contracts. Reform of debt repayment to 
international financial institutions and to lenders should be next on 
the agenda.
The World Bank
    In the past few years, the Administration and the Congress have 
insisted on some of the reforms advocated by the majority report of the 
International Financial Institution Advisory Commission. Monitored 
grants replaced some of the lending to the poorest countries. The 
Administration has worked to set explicit conditions that can be 
monitored and has introduced incentives for countries to meet those 
conditions. In its most recent budget, Congress required an independent 
performance audit of some IDA programs and insisted on greater 
transparency at the World Bank.
    These steps are a good start, but only a start. The central issue 
about the World Bank with its many programs is: It spends or lends 
about $20 billion a year but neither we nor they know which programs 
are effective and warrant expansion or retention, and which are 
ineffective and inefficient and should be abandoned. The monitoring 
that Congress insisted upon for part of IDA should be extended to the 
entire bank and its affiliates.
    There are two ways to gain the needed information. One is an 
independent performance audit by an outside agency. Another is 
development of an independent, internal group similar to the GAO or the 
IMF's Independent Evaluation Office. The current arrangement does not 
meet this standard.
    An example will bring out the problem. We have considerable 
evidence that poverty has declined dramatically measured by the number 
of people living on $1 per day or less. The decline is most striking in 
Asia especially in China and India. Market opening, private investment, 
protection of property rights, and the like contributed much to the 
improvement. Where these spurs to growth and development are largely 
absent, as in Sub-Saharan Africa, poverty has increased. Did World Bank 
programs contribute to the reduction of poverty in Asia? Did these 
programs ameliorate worsening prospects in Africa? The Congress should 
require answers to these questions.
    Further, the Bank should concentrate on the hard cases, the 
impoverished countries. The Bank should have an explicit program for 
graduation. Countries that can borrow in the capital markets with 
investment grade ratings should not receive subsidized loans. Those 
loans can be better used to provide potable water, sanitary sewers, 
disease control in the poorest countries, and to encourage countries to 
adopt 
institutional reforms that have been effective in spurring development. 
These include the rule of law, open trading arrangements, and 
protection of property rights and individual rights.
    Finally, we should insist that the IMF and the Bank eliminate 
overlapping responsibilities. The World Bank should become a more 
effective development bank. The Bank has estimated that $1 trillion a 
year is paid in bribes in all countries. A large part is in the 
developing countries. Ridding the system of corruption is a major 
challenge. The IMF's responsibility should remain the maintenance of 
global financial stability. As a result of experience in the Asian 
crisis, many Asian countries have accumulated substantial reserves to 
protect them against crises and to avoid being put under IMF 
supervision. They have also established a regional lending system 
outside the IMF. This, too, opens questions about the future role of 
the IMF.
    New leadership at the IMF and the end of James Wolfensohn's term at 
the Bank in 2005 provides an opportunity for new leadership, new 
approaches, and much needed reform.

                               ----------
                 PREPARED STATEMENT OF C. FRED BERGSTEN
            Director, Institute for International Economics
                              May 19, 2004

    I want to focus my remarks today on the issue I believe is both 
most important to the functioning of the international monetary system 
and has been least satisfactorily addressed over the past 5 years of 
debate on the future of the international financial architecture: The 
exchange rate levels and exchange rate systems among the major 
economies of the world. This includes China and several other large 
economies in East Asia along with the United States, Euroland, and 
Japan. I believe that the U.S. Treasury and the International Monetary 
Fund are violating their respective mandates concerning exchange-rate 
policy and that the Committee should address priority attention to this 
issue.
    Before addressing this major problem, I should note that there has 
been a considerable amount of good news on the exchange-rate front in 
recent years. A large majority of emerging market economies, and other 
developing countries, have shifted from fixed to flexible currency 
regimes and have thus insulated themselves from the types of crises 
that were so prevalent in the 1990's. In my view, this is in fact the 
central reform that has taken place in the international financial 
architecture and it will substantially reduce the systemic instability 
that was so prevalent in the recent past.
    Paradoxically, the chief problem now relates to the currencies of 
the major countries. The immediate issue is the massive intervention in 
the currency markets by China, Japan, Korea, Taiwan, and perhaps a 
couple of other countries to keep their exchange rates from rising 
against the dollar. China's intervention in 2003 exceeded the total 
increase in its GDP. Japan's intervention in the first quarter of this 
year exceeded the global total of the U.S. current account and budget 
deficits, that is, the Bank of Japan by itself more than financed all 
of our twin deficits. As a result of this intervention, all four 
countries cited here amassed foreign exchange reserves far in excess of 
any conceivable needs they might have--to levels of $850 billion for 
Japan, almost $500 billion for China, $200 billion for Taiwan, and $160 
billion for Korea.
    There are three very costly results of this process. First, much of 
the essential correction of the U.S. current account deficit is 
blocked. Despite the substantial (though gradual and orderly) fall of 
the dollar from early 2002 to early 2004 against the euro, Australian 
dollar, Canadian dollar, and a few other currencies, its trade-weighted 
average--which is what counts for purposes of trade adjustment--has 
only fallen by about 10 percent. This is largely because the Asian 
countries have resisted, partly or wholly, participating in the 
essential international adjustment.
    Our external deficit has now largely leveled off as a result of the 
modest dollar decline and may fall by as much as $100 billion, though 
last week's record numbers for the deficit remind us of the severity of 
the problem. In any event, it will remain unsustainably high. I believe 
that we need to cut the deficit by at least one half, from its present 
level of $550 billion to $250-$300 billion, to achieve a sustainable 
position. This will require a dollar decline of 25-30 percent, from its 
highs of early 2002, 2\1/2\-3 times what has occurred to date.
    Second, the distribution of the international currency (and thus 
economic) adjustment to date has been highly unbalanced. The euro and a 
few other currencies have risen by 40-50 percent against the dollar 
(and 10-25 percent on a trade-weighted basis). But the currencies of 
the Asian countries, which have been running the largest current 
account surpluses that are the primary counterparts of our deficits, 
have risen much less. In the key case of China, the currency has not 
increased at all because of its peg to the dollar. (Similar results 
obtain for Taiwan and a couple of the smaller countries.) This 
distorted distribution of currency movements has placed undue burdens 
on Europe, Australia, Canada, and several other countries. Since most 
of the Asian countries are growing rapidly and most of the Europeans 
are growing slowly, this distribution has dampened world growth. It has 
also understandably led the countries that have already appreciated to 
now resist significant additional appreciation until the Asians join 
the adjustment process, further truncating the necessary correction of 
the U.S. deficit.
    Third, China's peg to the dollar essentially blocks the 
participation of all of East Asia (even, to a partial extent, Japan) in 
the needed adjustment process. China is the world's most competitive 
major economy, and has become even more competitive as it has ridden 
the dollar down against virtually all other currencies, and its 
neighbors are understandably reluctant to let their currencies rise 
against the dollar because doing so would mean they would also rise 
against the renminbi. Thus Korea, Taiwan, and Japan have resisted fully 
participating in the global adjustment process along with China; their 
own trade-weighted exchange rates have either risen minimally (Japan 
and Korea) or declined (Taiwan).
    The obvious question is what to do about all this? The Treasury 
Department reported to the Congress on April 15 that it is 
``encourag(ing) . . . policies for large economies that promote a 
flexible market-based exchange rate.'' However, the report concluded 
that ``no major trading partner of the United States met the technical 
requirements for designation (for currency manipulation) under the 
Omnibus Trade and Competitiveness Act of 1988.'' Moreover, the 
International Monetary Fund ``concur(red) with our conclusions'' when 
Treasury consulted with them, as required by the statute.
    These conclusions by both the Treasury and the IMF are patently 
incorrect. China's huge intervention, which has prevented any 
appreciation of its currency against the dollar, is clearly intended to 
maintain an undervalued exchange rate to strengthen the country's 
international competitive position. Japan's even larger intervention 
has not precluded some significant rise in the yen but that rise would 
clearly have been much greater in the absence of Japanese official 
action. Similar conclusions obtain, on a lesser scale from a global 
standpoint, for Korea and Taiwan. Hence the Treasury Department by 
failing to act against this widespread manipulation is clearly 
violating both the letter and spirit of U.S. law.
    The IMF is likewise violating its own rules. Article IV, Section 1 
(paragraph iii) of its Articles of Agreement stipulate that each member 
shall ``avoid manipulating exchange rates . . . in order to prevent 
effective balance of payments adjustment or to gain unfair competitive 
advantage over other members.'' The Fund itself (Article IV, Section 3) 
is to ``exercise firm surveillance over the exchange rate policies of 
members'' and, under the principles and procedures adopted in 1977 
(after the initial advent of floating exchange rates), the first 
indicator of the need for such surveillance is ``protracted, large-
scale intervention in one direction in the exchange market.'' This is 
exactly what is happening in all the East Asian countries cited yet no 
discernible Fund action has been taken.
    The problem is further compounded by the erroneous nature of the 
advice that has been offered by the U.S. Treasury Department and the 
Fund (and the G-7) in their discussions of the issue with the Chinese. 
They have urged China to liberalize or dismantle its exchange controls, 
and float its currency, despite the totally unrealistic nature of any 
such move for at least a few more years in light of the weakness of 
China's banking system. Such advice, if accepted, could even produce 
net capital outflows from China that would weaken the renminbi, and 
intensify the global adjustment problem. China should instead retain 
its capital controls and fixed exchange rate, for a while longer, and 
deal with the immediate international problem (as well as its drastic 
domestic overheating) through a one-time revaluation of 20-25 percent.
    I conclude that the most urgent unresolved issue of the 
international financial architecture and the role of the IMF, at the 
current time, is how to get all major trading countries to participate 
fairly and effectively in the international adjustment process. 
Countries are never eager to adjust, so rules of the game have been 
developed at the national and international levels to assure that they 
do so. Both the Treasury and the International Monetary Fund are 
violating their obligations to promote global adjustment, however, and 
I urge the Committee insist that they do so.

                               ----------
               PREPARED STATEMENT OF DOUGLAS HOLTZ-EAKIN
                 Director, Congressional Budget Office
                              May 19, 2004

    Mr. Chairman and Members of the Committee, I appreciate the 
opportunity to 
appear today to discuss the costs and budgetary treatment of U.S. 
support for multilateral financial institutions (MFI's).\1\ At the 
request of the House Budget Committee, the Congressional Budget Office 
(CBO) has been examining the budgetary presentation of a variety of the 
Federal Government's financial transactions. The preliminary analysis 
that I present today derives from that effort.
---------------------------------------------------------------------------
    \1\ MFI's include the International Monetary Fund, multilateral 
development banks, and several other specialized financial 
institutions. Such banks include the World Bank, the Asian Development 
Bank, the Inter-American Development Bank, the African Development 
Bank, the North American Development Bank, and the European Bank for 
Reconstruction and Development. Other specialized organizations include 
the International Finance Corporation, the Inter-American Investment 
Corporation, and the Multilateral Insurance Guarantee Association.
---------------------------------------------------------------------------
    The United States supports MFI's to further its international 
economic and political policy objectives. In the process, it incurs 
costs. My focus today will not be the benefits of MFIs' operations but, 
instead, the economic measurement and budgetary presentation of the 
costs of MFIs' activities. I hope to convey the following key points:

 MFI's lend to countries that have often gone into arrears and 
    sometimes defaulted on their debts to other lenders.
 The operations of MFI's embody subsidies to borrowing 
    countries.
 Some of the features of world financial markets that protected 
    MFI's from loan losses in the past may not do so in the future.
 Therefore, U.S. taxpayers may bear some portion of those costs 
    in the future. The extent of that exposure will depend on the 
    financial structure of the MFI and the laws and institutions that 
    link it, the United States, and other relevant parties and the 
    United States' decision about replenishing the MFI's resources.
 To support well-informed policy decisions, the Federal budget 
    should recognize the magnitude of the United States' financial 
    commitments in a consistent fashion, including those of the various 
    MFI's.
 The current budgetary treatment of MFI's may fall short of 
    that goal.

    My statement does not attempt a comprehensive survey of MFI's, but 
rather focuses on three of the most important ones: The World Bank's 
International Development Association (IDA), which lends at 
``concessional'' terms--providing loans at below-market rates and with 
very long terms; the International Bank for Reconstruction and 
Development (IBRD), which undertakes most of the World Bank's 
``nonconcessional'' operations; and the International Monetary Fund 
(IMF). Each MFI poses different economic risks and different conceptual 
issues for the presentation of U.S. commitments in the Federal budget.
The Economic Costs of MFIs' Operations
    All loans present risks to the lender of nonrepayment (credit 
risk); and MFI's lend to particularly risky clients. Member countries 
that have borrowed from MFI's have often gone into arrears and 
sometimes defaulted on their debts to other lenders. They have 
restructured their debts, changed their future debt payment through 
rescheduling, and sometimes asked for debt forgiveness. For example, 
since 1990 borrowing members of the three MFI's have rescheduled about 
$270 billion of their loans from other governments--a figure that 
represented almost 60 percent of their nearly $450 billion in 
outstanding bilateral debt as of 2002. They have also rescheduled and 
reduced their debts to private banks. The resulting losses have been 
estimated at $61 billion between 1989 and 1995, or about one-third of 
the private-sector portfolio of $191 billion in loans to those 
borrowers.\2\
---------------------------------------------------------------------------
    \2\ William R. Cline, ``International Debt Re-examined,'' in 
Federal Deposit Insurance Corporation, An Examination of the Banking 
Crises of the 1980's and Early 1990's, vol.1 of History of the 
Eighties: Lessons for the Future (1995), pp. 234-235.
---------------------------------------------------------------------------
    Reflecting their credit risk, the debts issued directly by the 
governments of borrowing member countries--sovereign bonds--trade at a 
discount below U.S. Treasury securities with similar maturities and 
coupons. For example, such discounts have reached as much as 35 percent 
for Brazil and 80 percent for Argentina, both important borrowers from 
MFI's.
    MFIs' lending embodies subsidies to the borrowing countries. The 
economic magnitude of such subsidies can be gauged by comparing the 
book values of an MFI's loans--the dollar face value at the time the 
loans are made--with the corresponding market value. To estimate the 
market value, CBO used the market prices of borrowing countries' bonds 
with terms (maturities, coupon payments, and so forth) adjusted to be 
similar to those of MFI loans.
    Several important caveats apply to those calculations. First, as 
discussed at length below, the use of market prices as a point of 
comparison assumes lenders have equal seniority--a level playing field 
where one lender will not be paid before the others. Second, as with 
all such valuation estimates, they represent a snapshot; one could 
choose to make a valuation at several points in time. Third, CBO relied 
on several simplifying assumptions and approximations, including the 
adjustments to bonds terms, that were not exact. The results of the 
calculations are, therefore, best considered as approximations of the 
relevant costs.
The International Development Association
    Donor countries provide resources through capital subscriptions to 
IDA. It then lends that money to low-income countries that may have 
difficulty borrowing on international markets. The loans carry a zero 
interest rate, or, on occasion, IDA provides funds as grants. As of 
June 2003, its portfolio of outstanding loans had a book value of about 
$115 billion (see Table 1). In contrast, the market value of the loans 
was only about $20 billion.\3\ Therefore, subsidies by IDA totaled 
about $95 billion. Of that amount, about $7.1 billion resulted from 
lending that occurred in the previous fiscal year.
---------------------------------------------------------------------------
    \3\ For many IDA borrowers, no sovereign debt is traded in public 
markets. However, even assuming optimistically that IDA's borrowing 
members could borrow on the same terms as the United States, the length 
of loans and repayment schedules yield subsidies over 80 percent. 
Therefore, the probability of defaults has little influence on the 
estimated value of the loans.


The International Bank of Reconstruction and Development
    Member countries also pay in capital subscriptions to IBRD. Unlike 
IDA, however, IBRD increases its capacity to lend to developing 
countries by selling bonds in international capital markets.\4\ In June 
2003, IBRD had $11.5 billion in paid-in capital and $108.6 billion in 
outstanding debts. Those resources helped fund $116.2 billion in loans 
to developing countries.\5\ In addition to paid-in capital, IBRD 
members have agreed to provide another $178 billion in callable 
capital. Of that total capital, about $110 billion is payable by high-
income industrial countries.
---------------------------------------------------------------------------
    \4\ The World Bank also has $26.4 billion in retained earnings to 
buffer against defaults without calling for more capital. See World 
Bank, Annual Report, 2003, vol.1, table 1.
    \5\ World Bank, Annual Report, 2003, vol.1, table 11.
---------------------------------------------------------------------------
    In June 2003, IBRD's portfolio of all outstanding loans had a book 
value of $158 billion (see Table 2). The market value of the loans was 
considerably less--about $111 billion. Again, the gap between the book 
value and market value, or $47 billion, reflects the estimated costs of 
the subsidies inherent in IBRD's portfolio. Of that total, $7 billion 
in subsidies arose from IBRD's $11.2 billion in lending during the 
previous fiscal year. Those operations in 2003 give an indication of 
the economic subsidies in new loans. At the same time that IBRD 
originated about $11 billion in new loans, the market valued them at 
about $4 billion.


The International Monetary Fund
    IMF assigns member countries ``quotas,'' or capital subscriptions. 
Members pay their quota in two components. First, about a quarter is in 
highly liquid currencies, easily converted to other similar currencies. 
The remainder is in notes denominated in the member's own currency. 
Altogether, IMF members have paid quotas totaling about $300 
billion.\6\ In exchange, member countries have the right to withdraw 
the highly liquid currencies that they paid in and to borrow such 
currencies beyond what they paid in.
---------------------------------------------------------------------------
    \6\ International Monetary Fund, Financial Statements of the 
International Monetary Fund, Quarter Ended January 31, 2004, Balance 
Sheet, p. 3.
---------------------------------------------------------------------------
    When countries draw beyond their paid-in quotas, the terms for such 
loans vary, with repayment periods ranging from 2 years to 10 and 
interest rates starting from a basic rate (at present, about 2.7 
percent) and adding as much as 800 basis points (8 percentage points) 
for loans that are large relative to a member's quota.\7\
---------------------------------------------------------------------------
    \7\ How Does the IMF Lend: A Factsheet (April 2003), available at 
http://www.imf.org/external/np/exr/facts/howlend.htm; and SDR Interest 
Rate, Rate of Remuneration, Rate of Charge and Burden Sharing 
Adjustments, May 16, 2004, available at http://www.imf.org/external/np/
tre/sdr/burden/2004/051004.htm.
---------------------------------------------------------------------------
    For many member countries, the economic advantage arising from 
membership in IMF lies in being able to effectively exchange their own 
currency for highly liquid foreign currencies. Suppose, for example, 
that the Government of Argentina needed to make a payment on non-IMF 
international debts denominated in dollars. The government might 
perceive that buying the necessary dollars using Argentine pesos on 
international currency markets would adversely affect the dollar/peso 
exchange rate. If so, the government could borrow dollars from IMF, 
leaving the peso/dollar exchange rate unaffected, even as Argentina 
used those borrowed dollars to settle its debt obligation.
    How does such a transaction entail an economic cost? The main 
potential for subsidy arises when IMF lends strong, liquid currencies, 
such as the dollar, and gets in exchange from the borrowing countries 
promissory notes for repayment 2 to 10 years in the future that they 
may be unable to fully honor.
    In June 2003, IMF had a portfolio of outstanding loans with a book 
value of $121 billion. However, valued using the market prices of 
comparable private-sector bonds, the portfolio would be worth $60 
billion. That is, IMF members lent $121 billion in exchange for assets 
with an estimated value of $60 billion and thereby provided subsidies 
of about $61 billion. Of that amount, $6.4 billion arose in the 
previous fiscal year, when IMF made loans of $41 billion that had a 
market value of roughly $35 billion.


Estimating the U.S. Share in the MFI's
    An important step in assessing the potential treatment of U.S. 
commitments in the Federal budget is gauging the magnitude of the 
country's role in MFI's. The size of the United States' share depends 
on its share of the capital or of the quotas of the MFI in question. 
Those shares are set out in MFIs' articles of agreement and in their 
boards of governors' resolutions.
    For IDA, since all funds are actually paid in, the United States' 
share is a relatively unambiguous 21.7 percent.
    For IBRD, the United States' nominal share of paid-in and callable 
capital is 14 percent. Alternatively, it may be the case that other 
countries are unable to absorb their full nominal share. If so, a more 
relevant indicator may be the market value. The U.S. share of the 
market value of that capital is about 22 percent. Thus, a rough 
estimate of the U.S. share lies in the range of 14 percent to 22 
percent.
    For IMF, the United States' share is based on the amount of gold 
and currency that it has paid in over the years. Nominally, the U.S. 
share of the fund's resources and obligations is 17 percent. However, 
only part of IMF's resources can be used to settle accounts, the usable 
currencies--the U.S. share of which is about 22 percent. Thus, an 
estimate of the U.S. share lies between 17 percent and 22 percent.
Changes in Financial Markets Affecting MFIs' Prospects for Loan Losses
    The preceding discussion contained estimates of the value of MFI 
portfolios--in particular, new lending--using market prices for 
publicly traded bonds and assuming that the debts owed to MFI's are on 
a level playing field with loans from other lenders. But if the claims 
of MFI's were senior to the claims of private bondholders, then MFI 
loans would be less risky. Accordingly, using prices of those sovereign 
bonds to estimate the value of MFIs' portfolios would underestimate the 
value of MFI loans because higher seniority would mean that the loans 
would be paid off first in the event of financial trouble in the 
borrowing country. Therefore, using market rates would overstate the 
costs of the subsidies arising from MFI loans.
    Seniority, particularly the future treatment of new lending, 
therefore, bears critically on determining the potential future costs 
of U.S. participation in MFI's. According to both IMF and the World 
Bank, MFI's do not have seniority established by law or by the 
provisions of the loan agreements. But even without such legal 
standing, seniority can arise in practice. Determining such ``practical 
seniority'' is complex.
    For the past 60 years, most borrowers have fully repaid their debts 
to MFI's, sometimes even as they were going into arrears, rescheduling, 
or requesting forgiveness on their debts to other lenders. From that 
record, one could conclude that the claims of MFI's are not subject to 
the same risk as the publicly traded bonds of borrowing countries.
    However, some of the features of world financial markets that 
insulated MFI's from defaults in the past may not do so in the future. 
The effective seniority of MFI loans has been weakened by the reduced 
importance of bilateral (government-to-government) and commercial bank 
lending and by the increasing importance of private bondholders. Those 
changes in the sources of lending have reduced the flexibility of 
rescheduling debt payments to MFI's.
    At the beginning of the 1990's, three groups had made substantial 
loans to MFI member countries. The MFI's themselves lent nearly 
exclusively to governments. Other countries, or bilateral lenders, 
organized for debt-negotiation purposes as the ``Paris Club,'' provided 
loans or loan guarantees to borrowing governments. Finally, private 
international banks, organized for debt-negotiation purposes as the 
``London Club,'' made private loans to governments or to private agents 
who had guarantees from MFI borrowing members. Each group of lenders 
accounted for a sizable share of the debts of MFI borrowing members 
(see Figure 1). As I shall describe, IMF played a key role in 
coordinating the groups.


    When a borrowing member of an MFI could not pay all of its loans, 
it would go to IMF and negotiate a plan for restructuring and 
rescheduling its debts, usually on the condition of changing its 
domestic economic policies. Negotiated agreements with IMF set out, 
among other terms, the maximum total debt repayment that a country 
would be expected to pay in each year.
    The participation of the Paris Club, which would meet to consider 
debt forgiveness or rescheduling, was often crucial to success. In 
those negotiations, the Paris Club operated strictly in tandem with 
IMF. In particular, the Paris Club did not meet to consider 
rescheduling unless the debtor had negotiated a ``program'' with IMF.
    Similarly, according to documentation by the Paris Club, a 
prerequisite for its own agreements was ``burden sharing'' with the 
commercial banks constituting the London Club. Consequently, IMF 
programs generally included payments to the London Club.
    IMF programs provided for rescheduling debts owed to commercial 
banks and bilateral lenders and did not provide for rescheduling MFI 
debts; that is, MFI's were paid first. As a practical matter, then, IMF 
programs gave MFI's seniority over bilateral lenders and private banks.
    Historically, the Paris Club's willingness and ability to make new 
financial resources available to MFI borrowers through rescheduling has 
been a key element in establishing MFIs' practical seniority. For the 
Paris Club to continue to protect MFIs' seniority in that way, though, 
the debts owed to Paris Club creditors must be sufficiently large in 
relation to the debts owed to MFI's. If the amounts owed to the Paris 
Club are smaller, rescheduling the debts will be less helpful in 
permitting the continued servicing of the MFI debts.
    MFI lending members have experienced what happens when bilateral 
debts are not large enough to be rescheduled and, thereby, permit the 
servicing of MFI loans. For what are termed ``heavily highly indebted 
poor countries,'' bilateral debts had declined steadily relative to the 
debts owed to MFI's. By 1995, there was only $2 in bilateral debt per 
dollar of MFI debt (see Figure 2). Rescheduling Paris Club debts could 
not provide enough additional resources to permit continuing the timely 
servicing of the debts owed to MFI's. In the fall of 1996, the World 
Bank and IMF proposed relief for those countries, which came in the 
form of additional grants by the United States and other wealthy 
countries, sales of gold by IMF, and grants from the World Bank 
(drawing on its retained earnings).\8\ So far, the relief provided to 
the heavily indebted poor countries has amounted to $31 billion.\9\
---------------------------------------------------------------------------
    \8\ See World Bank, ``The HIPC Debt Initiative,'' available at 
http://www.worldbank.org/hipc/about/hipcbr/hipcbr.htm; and 
International Monetary Fund, ``Debt Relief Under the Heavily Indebted 
Poor Countries (HIPC) Initiative'' (April 2004), available at http://
www.imf.org/external/np/exr/facts/hipc.htm.
    \9\ International Monetary Fund, ``Debt Relief Under the Heavily 
Indebted Poor Countries (HIPC) Initiative.''


    For other countries borrowing from MFI's, too, bilateral and bank 
debt relative to MFI debt has fallen, from almost $6 per dollar of MFI 
debt in 1980 to about $2 in 2000. Argentina and Brazil, for example, 
have bilateral debts amounting to less than 10 percent of MFI debts, so 
any rescheduling of bilateral debts would have little relevance in 
facilitating the repayment of their MFI debts.
    A second shift in financial markets that may have diminished MFIs' 
practical seniority is the increasing importance of private 
bondholders. In 1990, private bondholders held small amounts of 
sovereign debt, but in 2002, they held about one-fourth--more than that 
owed to MFI's (see Figure 1). MFI's do not have legal 
seniority over private bondholders, and the bondholders are subject to 
none of the institutional arrangements among the MFI's, the Paris Club, 
and the London Club that coordinated payments and fostered MFIs' 
practical seniority in the past.\10\
---------------------------------------------------------------------------
    \10\ In 2003, IMF proposed a ``sovereign debt restructuring 
mechanism'' (SDRM) that would provide it legal seniority over private 
bondholders. Those bondholders objected, and the U.S. Treasury did not 
support the change. Consequently, IMF dropped the proposal for the 
SDRM.
    See International Monetary Fund, Proposals for a Sovereign Debt 
Restructuring Mechanism (SDRM): A Factsheet, available at http://
www.imf.org/external/np/exr/facts/sdrm.htm; Paul Blustein, ``Bankruptcy 
System for Nations Fails to Draw Support,'' Washington Post, April 2, 
2003, available at www.washingtonpost.com; and Anne O. Krueger, First 
Deputy Managing Director, International Monetary Fund, address given at 
the International Monetary Seminar, Banque de France, May 13, 2003, 
available at http://www.imf.org/external/np/speeches/2003/051303a.htm.
---------------------------------------------------------------------------
    Moreover, as borrowing countries turn more toward lenders in the 
private sector, during times of distress they may be more willing to 
continue to service their private-sector debts in order to retain 
access to those lenders. That shift may further diminish the practical 
seniority that MFI's have held.\11\
---------------------------------------------------------------------------
    \11\ A U.S. Treasury official recently noted the rising importance 
of private-sector lending and its potential for further growth. See 
John B. Taylor, Under Secretary of Treasury for International Affairs, 
address given at the IMF conference in honor of Guillermo Calvo, April 
16, 2004, available at http://www.treas.gov/press/releases/js1473.htm.
---------------------------------------------------------------------------
    The legal landscape, too, raises the possibility of diminishing 
practical seniority for MFI's. In a recent case, a private U.S. 
creditor did not accept Peru's restructuring of its foreign debt.\12\ 
The creditor obtained a judgment against Peru in the Federal District 
Court for the Southern District of New York. However, the creditor was 
unable to attach assets in the United States but then obtained an order 
from a Brussels court enjoining the Euroclear System from processing 
Peru's payments on the restructured bonds. The creditor was successful 
in arguing that Peru could not pay one group of creditors before paying 
it because of the ``pari passu'' clause in the bond agreements 
requiring equal treatment in payments to creditors.
---------------------------------------------------------------------------
    \12\ Elliott Assocs., L.P., v. Banco de la Nacion, 194 F.R.D. 116 
(S.D.N.Y. 2000).
---------------------------------------------------------------------------
    The argument accepted by the Brussels court is currently before the 
Federal 
District Court for the Southern District of New York in connection with 
the debt of Argentina. Concerned about the possibility that the private 
creditors would be successful in applying the Brussels decision, the 
Department of Justice submitted a ``statement of interest'' brief 
contending that any interpretation of the pari passu clause that would 
prevent nations from continuing to service their debts owed to MFI's in 
times of financial crisis was ``contrary to U.S. interests.'' \13\ The 
ongoing litigation leaves the future of MFIs' seniority unresolved.
---------------------------------------------------------------------------
    \13\ See David N. Kelley, U.S. Attorney for the Southern District 
of New York, Statement of Interest of the United States before the 
United States District Court, Southern District of New York, 
Macrotecnic International Corp. v. Republic of Argentina, 02 CV 5932 
(TPG), and EM, Ltd., v. Republic of Argentina, 03 CV 2507 (TPG).
---------------------------------------------------------------------------
To What Extent Could Losses by MFI's Accrue to the U.S. Budget?
    As operating entities, MFI's have retained earnings, reserves, and 
precautionary balances that could cover some loan losses. Those 
resources might postpone calls on the U.S. budget. However, MFI's may 
not have enough resources to cover all such losses; in fact, to the 
extent that MFIs' assets are correctly valued at market prices, the 
institutions currently have a negative net worth. Moreover, as economic 
entities, MFI's have no independent source of resources beyond those 
contributed by their members or any earnings from those contributions 
that the MFI's retain (which remain the property of their members).
    Under IDA's articles of agreement, no further call on U.S. 
resources may occur as a result of the association's activities. 
Furthermore, because IDA borrowers have been repaying their loans, the 
association has funds on hand. But the risk revealed by discounts on 
private-market bond prices and the long terms of the loans at a zero 
interest rate suggest a high probability of future credit losses, the 
potential exhaustion of IDA's capital, and the need for additional 
resources. In those circumstances, if the Congress followed past 
practice, it might choose to appropriate additional funds to IDA. 
However, IDA's articles of agreement do not compel the United States to 
honor any of the association's commitments over and above the money 
paid in.
    IBRD's articles of agreement provide for no automatic call on U.S. 
resources as a result of the bank's activities. In the event that the 
developing countries borrowing from IBRD did not pay their loans and 
the defaults exceeded IBRD's retained earnings, it would have to call 
for capital to repay the outstanding debts held by its bondholders. 
Over and above the $2 billion in capital that the United States has 
already paid in, the country has agreed to pay in another $30 billion 
in callable capital should such an event materialize.\14\
---------------------------------------------------------------------------
    \14\ World Bank, Annual Report, 2003, vol.1, table 11.
---------------------------------------------------------------------------
    In addition to its paid-in capital of about $11 billion, IBRD has 
$26 billion in retained earnings from its previous operations. It could 
use those funds to cover loan losses before calling for additional 
capital. Because the U.S. share of IBRD's 
resources is between 14 percent and 22 percent, the loss of those 
resources would represent a substantial cost to the United States. If 
defaults exceeded retained earnings and paid-in capital, IBRD would 
have to call for capital, including from the United States. The 
Congress has appropriated about $7.4 billion for that purpose, so the 
Treasury could provide up to that amount without additional 
Congressional action.
    IMF, like IDA, has no claim under its articles of agreement to more 
funds from the United States. Its holdings of gold, amounting to $41.3 
billion, cannot be used to finance its lending operations, but it has 
been building precautionary balances over the past several years; in 
2003, those balances amounted to about $8.4 billion.\15\ Any defaults 
would reduce the balances but would not automatically lead to a call on 
U.S. resources.
---------------------------------------------------------------------------
    \15\ See International Monetary Fund, Financial Risk in the Fund 
and the Level of Precautionary Balances, February 3, 2004, table 4, as 
of October 2003, available at http:// www.imf. org/external/np/tre/
risk/2004/020304.pdf.
---------------------------------------------------------------------------
The Budgetary Treatment of MFI's
    The budgetary treatment of the costs associated with MFI's has 
changed over time and is not uniform among them.
    Since 1960, for multilateral development banks (MDB's), including 
the World Bank and other banks not discussed in this statement, the 
budget has recorded $4.6 billion in paid-in capital and $39.5 billion 
in direct contributions. The budget reflected those transactions in the 
traditional manner, as both budget authority and outlays provided to 
the MDB's.
    Over that period, the United States has made about $62 billion in 
commitments of callable capital to the MDB's. Before 1981, the Congress 
appropriated budget authority to the U.S. Treasury to back the 
commitments. Those appropriations totaled slightly more than $12 
billion through 1980, and all of those funds remain as unspent, 
unobligated balances at the Treasury. In 1981, the approach of 
specifically appropriating budget authority for callable capital was 
dropped. The Congress has continued to provide new limitations on 
callable capital, bringing the total commitment level since 1960 up to 
about $60 billion, with about $22 billion provided in the 1980's and 
$34 billion in the 1990's (only about $1 billion in callable capital 
has been provided in the past 5 years). No budgetary resources have 
been specifically appropriated to cover those additional commitments.
    For IMF over the past 40 years, the budget has recorded $42.4 
billion in quota payments and $9.7 billion in other special-purpose 
payments. Dating back to the 1967 President's Commission on Budget 
Concepts, transactions with IMF have been recorded as a means of 
financing because the United States receives special drawing rights 
equal to the amounts paid in (and therefore the transaction has been 
viewed as an exchange of assets of equal value).
    However, there are other financial activities associated with the 
United States' membership in IMF. When the U.S. Treasury sends money to 
IMF, it gets a reserve position with the fund that forms a portion of 
the Treasury's monetary assets. IMF pays interest to the Treasury on 
most of its reserve position. Those interest collections are recorded 
in the budget as net interest receipts. The amount of interest 
received by the U.S. Government is net of the charges (burden sharing) 
that IMF levies on creditor countries to cover the estimated risk of 
IMF loans. In contrast to those earnings, however, the Treasury has 
realized interest costs because the money on deposit with IMF increases 
the requirement for the Treasury's borrowing from the public.
    As with any foreign exchange asset, the dollar value of the reserve 
position rises or falls with the exchange rate. The changes in that 
valuation are recorded in the budget as outlays. If the dollar 
strengthens, the value of other currencies and thus the reserve 
position decreases, and that change is recorded as a positive outlay. 
If the dollar falls in value, the value of the reserve position in 
dollars increases, and the change is recorded as a negative outlay. 
Those valuation adjustments are recorded in the budget under the 
international affairs area.
    The current budgetary treatment does not fully reflect the U.S. 
share of the credit risk associated with the lending and other 
transactions of MFI's. However, the budget records actual cashflows to 
and from MFI's, and resources remain in the Treasury to cover a portion 
(about one-fifth) of the United States' commitments for calls for 
capital.
    When considering how to display in the budget the costs associated 
with MFI's, three important questions stand out:

 Should the budget record primarily the cashflows to and from 
    MFI's, as it does today, or should it seek to also record and 
    provide resources for potential future risks associated with MFIs' 
    lending and other transactions?
 If the latter, after the funds are first provided, should the 
    estimates of costs be updated and the differences recorded in the 
    budget on a regular (for example, annual) basis?
 Should the budget attempt to record the credit risk associated 
    with the United States' past investment and commitments to MFI's or 
    only the risks associated with the new resources provided?

    CBO's work on these issues is not yet complete. The analysis will 
be more fully developed and subject to CBO's formal review process, 
which includes review by outside experts. The completed analysis will 
be presented in a forthcoming paper.
    Mr. Chairman, that concludes my statement today. I welcome any 
questions that you or Members of the Committee may have.




