[Economic Report of the President (1999)]
[Administration of William J. Clinton]
[Online through the Government Printing Office, www.gpo.gov]




CHAPTER 7
The Evolution and Reform of the International Financial System

The financial problems that began in Asia in the second half of 1997
have exposed weaknesses both in emerging market countries and in the
international financial system. In response, the United States has taken
steps, jointly with the international community, not only to contain the
financial crisis but also to foster reforms of the international
financial system to make it less crisis prone in the future. The recent
turmoil followed a robust period of increasing integration of world
product and financial markets--a trend well epitomized by the long-
anticipated realization of European Monetary Union in January 1999.
The recurrence of currency and financial crises in the world economy
poses major challenges to policymakers. What are the causes of these
repeated crises, and of instability and financial market volatility? Are
financial integration and globalization partly to blame? Does
integration into modern global financial markets require the loss of
macroeconomic policy autonomy? What regime of exchange rates is best for
emerging market economies and other small countries in this new world of
global capital mobility? Can the Bretton Woods institutions--the
International Monetary Fund (IMF) and the World Bank--which were
designed for a world of fixed exchange rates and limited capital
mobility, still promote the stability of the international financial
system in a radically different environment? What institutional
framework best promotes the stability of the international financial
system? Answers to these questions will be critical to efforts to
strengthen the stability of the international financial system and help
to ensure that global financial integration will continue to sustain
prosperity and growth in the world economy.
A broad international consensus now supports reform of the global
financial architecture to achieve several goals: to increase
transparency (that is, to improve the availability of information about
macroeconomic and financial conditions); to strengthen and reform
domestic financial institutions so as to prevent crises from occurring;
and to improve the mechanisms available to resolve those crises that do
occur. This chapter starts by describing proposals that have been
advanced in each of these three areas. It then analyzes the next steps
that are being considered in the redesign of the international financial
system. Finally, it considers European Monetary Union, the prospects for
the euro as an international currency, and the possible implications for
the U.S. dollar.

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REFORM OF THE INTERNATIONAL FINANCIAL ARCHITECTURE

As explained in Chapter 1, the international community, under U.S.
leadership, has proposed a set of reforms to strengthen the
international financial system. These reforms, designed to reduce the
incidence of future crises, are referred to collectively as the ``new
international financial architecture.'' Their aim is to create an
international financial system for the 21st century that captures the
full benefits of global markets and capital flows, while minimizing the
risk of disruption and better protecting the most vulnerable groups in
society. The work accomplished toward these goals in 1998 was only the
latest stage in an evolutionary process that has been under way for some
years.

FROM THE HALIFAX SUMMIT TO THE G-22 REPORTS

A broad debate on the steps needed to strengthen the international
financial system was already under way when the Mexican peso was
devalued suddenly in December 1994. The ensuing crisis, however, gave
the debate considerable impetus and pertinence. The annual summit of the
leaders of the Group of Seven (G-7) nations (Canada, France, Germany,
Italy, Japan, the United Kingdom, and the United States) in 1995, held
in Halifax, Nova Scotia, initiated work in a number of areas. One such
area was additional study of means to promote the orderly resolution of
future financial crises. The finance ministers and central bank
governors of the G-10 countries were asked to review a number of ideas
that might contribute toward that objective. The G-10 (which actually
has 11 members: the G-7 plus Belgium, the Netherlands, Sweden, and
Switzerland) established a working party, which submitted a report--
informally known as the Rey Report, after the chairman of the working
party--to the ministers and governors in May 1996.
The report noted recent changes in financial markets that, in some
cases, have altered the characteristics of currency and financial crises
in emerging markets. It indicated that neither debtor countries nor
their creditors should expect to be insulated from adverse financial
consequences in the event of a crisis. It also called for better market-
based procedures for the workout of debts when countries and firms are
in financial distress. Reforms of bond contracts were proposed to
encourage the cooperation and coordination of bondholders when the
financial distress of a country or a corporation requires the
restructuring of the terms of a bond. The report also suggested a review
of IMF policies on ``lending into arrears'' to extend the scope of this
policy to include new forms of debt. Such policies would allow the IMF
to continue lending, in certain unusual and extreme circumstances, to
countries that had temporarily suspended debt-service payments but

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continued to maintain a cooperative approach toward their private
creditors and to comply with IMF adjustment policies.
A number of important innovations came out of this reform process:
the development of international standards for making economic data
publicly available (under the IMF's Special Data Dissemination
Standard); international standards for banking supervision (the Basle
Core Principles for Banking Supervision); the decision to expand the
IMF's backup source of financing under the New Arrangements to Borrow
(25 participants in the NAB agreed to make loans to the IMF when
supplementary resources are needed to forestall or cope with an
impairment of the international monetary system, or to deal with an
exceptional situation that poses a threat to its stability); and, more
recently, a new financing mechanism in the IMF, called the Supplemental
Reserve Facility, to help members cope with a sudden and disruptive loss
of market confidence, but on terms designed to encourage early repayment
and reduce moral hazard.
Despite some progress in strengthening the system, the eruption of
the Asian crisis in 1997 demonstrated the importance of considering
further questions regarding the operation of the international system.
In November 1997, on the occasion of the Asia-Pacific Economic
Cooperation leaders' summit in Vancouver, a number of Asian leaders
proposed a meeting of finance ministers and central bank governors to
discuss the crisis and broader issues. They suggested that participation
in the meeting be expanded to include emerging market countries, not
just the usual small number of major industrial countries. The President
responded by calling on the Secretary of the Treasury and the Chairman
of the Board of Governors of the Federal Reserve System to convene such
a meeting. Finance ministers and central bank governors from 22
systemically significant countries in the international financial system
(informally dubbed the Group of 22, or G-22) gathered in Washington on
April 16, 1998, to explore ways to reform the system that could help
reduce the frequency and severity of crises. Three working groups were
formed to consider the following three sets of issues: measures to
increase transparency and accountability, potential reforms to
strengthen domestic financial systems, and mechanisms to facilitate
appropriate burden sharing between official institutions and the private
sector in time of crisis. The three working groups presented their
reports in October 1998 on the occasion of the annual meetings of the
IMF and the World Bank.

GREATER TRANSPARENCY AND ACCOUNTABILITY

The report of the first working group reflects the existence of a
broad consensus on the need for greater transparency not only by the
private sector and national authorities but by the international
financial institutions (IFIs) as well. The Asian crisis made clear once
more that it is important for countries to provide sufficient
information

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about their macroeconomic and financial conditions. The information
needed includes data on the size, maturity, and currency composition of
external liabilities, as well as accurate and comprehensive measures of
the level of foreign exchange reserves. The crisis also underscored the
need for banks and corporate enterprises to provide accurate information
about their financial accounts. Without such information, outsiders
cannot adequately assess the true financial condition of governments and
firms. The crisis made clear as well the importance of transparency on
the part of the IFIs themselves, and led to calls for the IMF and other
IFIs to be more open about their activities, economic analysis, policy
advice, and recommendations.
The report of the G-22 working group on transparency and
accountability recommends that national authorities publish timely,
accurate, and comprehensive information on the external liabilities of
the financial and corporate sectors in their countries as well as their
own foreign exchange positions. Published information on official
foreign exchange positions would extend to both reserves and
liabilities, for example those deriving from government intervention in
forward exchange markets. The report recommends adherence to existing
international standards for transparency and finds that standards in
additional areas, including monetary policy and accounting and
disclosure by private financial institutions, might be useful. The
report calls for better monitoring of countries' compliance with such
standards, including through IMF reporting on countries' adherence to
internationally recognized standards. It also recommends that the
potential for greater transparency of the positions of investment banks,
hedge funds, and institutional investors be examined.
Finally, the report calls on the IMF and the other IFIs to be more
open and transparent. Accountability, it argues, is important for all
institutions, and unnecessary secrecy would be particularly
inappropriate in institutions that are telling others to be more
transparent. For example, the report recommends that IFIs adopt a
presumption in favor of the release of information, except where
confidentiality might be compromised. It also calls for publication of
program documents, of background papers to reports following the regular
yearly visit by the IMF to a member state, of public information notices
following the IMF Executive Board's discussion of reports on member
countries' economic conditions, of retrospective program reviews, and of
other policy papers.
Increased transparency can help prevent the buildup of countries'
financial and macroeconomic imbalances. In the Asian crisis, for
example, more information concerning the external debt of firms and
banks might have limited investors' willingness to lend to such
institutions in the first place. Transparency can also encourage more
timely policy adjustment by governments and help limit the spread of
financial market turmoil to other countries by enabling investors to
distinguish

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countries with sound policies from those with weaker policies.
Nonetheless, transparency alone is unlikely to be sufficient to prevent
another major crisis from occurring. In Asia, greater transparency about
net reserves and offshore liabilities of the financial and corporate
systems might well have helped attenuate the crisis. But investors also
missed many warning signals in data that were widely available. More is
needed than just information.

REFORMING AND STRENGTHENING DOMESTIC FINANCIAL INSTITUTIONS

As discussed in Chapter 6, weaknesses in the financial sectors of
borrowing countries now appear to have been a central cause of the Asian
crisis, and of some previous financial crises as well. Commercial banks
and other financial institutions borrowed and lent imprudently,
channeling funds toward projects that were not always profitable.
Insufficient expertise and resources in countries' regulatory
institutions led to weak regulation of the financial system, and in
particular to lax supervision of banks. Insurance of bank deposits was
either implicit or poorly designed. Often, governments did not provide
explicit deposit insurance; rather, they implicitly insured the
liabilities of the banking system. Connected lending was widespread:
banks and other financial firms in a business group would make loans to
other firms in the group without objectively evaluating or monitoring
their soundness. The result was often distorted incentives for project
selection and monitoring. All these factors contributed to the buildup
of severe structural weaknesses in the financial system, the most
visible manifestation of which was a growing level of nonperforming
loans. The growing supply of funds from abroad, facilitated in part by
capital account liberalization, only heightened the problem; rising
capital inflows combined with poorly regulated and often distorted
domestic financial systems to create a dangerous environment.
Strengthening domestic financial systems, the focus of the second G-
22 working group, will thus be a central element of ongoing systemic
reform. The list of measures required is long and will take years to
complete. The reforms recommended by the G-22 report include the
development of liquid and deep financial markets, especially markets in
securities (bonds and equities). Financial markets should be able to
rely on strong prudential regulation and supervision of banks and other
financial institutions, based on the Basle Core Principles of Banking
Supervision and the Objectives and Principles of Securities Regulation
set out by the International Organization of Securities Commissions.
Appropriate restrictions on connected lending would be beneficial. The
working group's report also calls on countries to design explicit and
effective deposit insurance mechanisms to protect bank depositors. The
report also calls for better corporate governance in both the financial
sector and the nonfinancial sector, so that investment

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decisions respond to market signals rather than to personal
relationships. It further recommends the design and implementation of
bankruptcy and foreclosure laws for insolvent firms and, more broadly,
the implementation of efficient insolvency and debtor-creditor regimes,
possibly including procedures for systemic bank and corporate
restructuring and debt workouts for corporations in financial distress.
Finally, the report advocates better coordination and cooperation among
international organizations and international supervisory entities in
strengthening financial systems, as well as increased technical
assistance for and training of government officials and regulators.

BETTER CRISIS RESOLUTION, INCLUDING APPROPRIATE ROLES FOR THE OFFICIAL
COMMUNITY AND THE PRIVATE SECTOR

Although strengthening financial systems may prevent some crises
from occurring and make those that do occur less virulent, it cannot be
expected to eliminate them altogether. It is therefore essential to
establish means of minimizing the depth and severity of crises without
undermining appropriate incentives for prudent private and public
behavior. This very important task constitutes the third and final
pillar of the set of international financial reforms proposed in October
by the G-22 working groups.
The G-22 report on this topic identifies policies that could help
promote the orderly resolution of future crises, including both official
assistance and policies and procedures that could facilitate the
involvement of the private sector as appropriate. It noted that recent
events have highlighted how the larger scale and greater diversity of
recent capital flows to emerging markets generate the risk that crises
can erupt more quickly and can be larger in scope than in the past. It
is of critical importance that the IMF and the other IFIs remain capable
of catalyzing policy reform and the restoration of market confidence in
their member countries in the event of an international financial
crisis, in the context of a strong program of policy adjustment. The
combination of adjustment and financing should be sufficient to resolve
most payments difficulties. However, the scale of private capital flows
significantly exceeds the resources that the official community can
reasonably provide, even with the quota increase to bolster IMF
resources and other measures. Moreover, the perception that sufficient
official financial assistance may be made available to allow a country
to meet all contractual obligations without some form of appropriate
private sector involvement might distort the incentives of both
creditors and debtors. It may encourage some creditors to take
unwarranted financial risk, some debtor countries to follow
inappropriate policies, and both debtors and creditors to underestimate
the risks they are assuming. Although the international community will
continue to provide assistance--conditioned on economic reform--to deal
with the prob-

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lems that have given rise to crises, mechanisms are needed to allow the
private sector to participate constructively in containing crises and
resolving them over time. Work is under way to find constructive and
cooperative ways to ``bail in'' private investors.
New procedures suitable to modern markets might be usefully
developed for effective management of the financial difficulties of both
firms and countries. When banks accounted for the majority of
international capital flows, as in the 1970s and 1980s, troubled debtors
could more easily resolve a crisis through joint negotiations with a
small number of banks and the IFIs. Negotiations such as those developed
to address the 1980s debt crisis entailed agreements to postpone debt
repayments (debt restructuring) and occasionally to reduce the overall
value of the obligation (debt writedown). However, the recent
proliferation of creditor institutions and instruments and the growth of
international bond markets have made it harder to coordinate the actions
of creditors during a crisis. Unilateral actions by troubled debtors
are, on the other hand, highly disruptive and can lead to contagion, if
they increase investors' concern that other countries may follow suit.
This might explain why Russia's unilateral debt restructuring in August
1998 disrupted markets as far away as Latin America.
Recognizing the need for new procedures, the G-22 report includes a
number of recommendations. First, it calls for a range of policies to
help prevent crises and limit the severity of those that do occur. The
report emphasizes that countries might want to limit the scope of
government guarantees, including those covering the liabilities of
financial institutions, and to make explicit those guarantees that are
offered and price them appropriately (for example, through effective
deposit insurance). In addition, the report endorses the development of
innovative financing techniques to permit increased payment flexibility,
greater risk sharing among debtors and creditors, or the availability of
new financing in the face of adverse market developments such as sudden
reversals of capital flows. For example, debt contracts calling
explicitly for repayments contingent on the prices of key primary
commodities could automatically reduce countries' debt burdens when
prices move against them.
Finally, the report identifies key features of effective insolvency
and debtor-creditor regimes (including bankruptcy, restructuring, and
foreclosure laws) and highlights the role of such regimes in
contributing to effective crisis containment and resolution. Workable
procedures in these areas may be useful to encourage the prompt recovery
of economic activity following a financial crisis. Among the most
important basic objectives of an insolvency regime are to maximize the
value of a firm's assets after its liquidation or reorganization; to
provide a fair and predictable regime for the distribution of assets
recovered from debtors; and to facilitate the uninterrupted provision of
credit for commercial transactions by providing an orderly regime for
the distribution of debtors' assets.

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Other measures recommended by the working group would encourage the
coordination of creditors in the event of a crisis. Following the
recommendations of the 1996 Rey Report, the G-22 report proposes the
inclusion of creditor coordination clauses in bond contracts. These
clauses would be designed to create an environment in which all
parties--creditors, debtors, and IFIs--can work together to resolve
crises in the most advantageous manner possible. Collective action
clauses in bond contracts could help overcome the problems to which a
large number of creditors inevitably gives rise. For example, a clause
allowing for the collective representation of creditors (such as through
the formation of a creditors' committee) can help facilitate coordinated
action among a large group of creditors. A majority action clause could
prevent a small minority of creditors from impeding a debt-restructuring
agreement, by allowing a qualified majority of creditors to alter the
payment terms of the debt contract. Currently, most sovereign bond
contracts in the United States require unanimity to restructure the
terms of the contract. Similarly, sharing clauses would mandate the
equal treatment of creditors by imposing a fair division of payments
among them. This could discourage disruptive legal action and
preferential settlements that benefit a few creditors at the expense of
others.
The report also calls for new methods of crisis management in the
extreme case of a temporary suspension of debt payments. Recent
experience (as in Russia in 1998) underscores the fact that such
suspensions and unilateral restructuring actions can be highly
disruptive, especially if they substitute for policy reform and
adjustment. The G-22 report argues that countries should not, and
normally would not, suspend debt payments (interest and principal) until
all other reasonable alternatives have been exhausted. However,
suspension might occur in exceptional cases, in the event of severe and
unanticipated adverse market developments. In these cases, the report
emphasizes the importance for countries to rely on orderly and
cooperative approaches, rather than unilateral actions, in negotiating
the restructuring of contractual obligations. Unilateral action may
entail significant economic and financial costs.
If a country does suspend its debt payments to private creditors, it
is technically in arrears. The report argues that, in those exceptional
cases when a country experiences a severe crisis and a temporary
payments suspension cannot be avoided, the international community and
private creditors may still have an interest in providing incentives for
strong and sustained policy adjustments and structural reform. It
therefore suggests that the international community can signal its
conditional willingness to provide financial support, under appropriate
conditions, even if a country has imposed a temporary payments
suspension. The report argues that such official support should be
provided only if the decision to suspend payments reflects the absence
of rea-

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sonable alternatives, if the government is willing to undertake strong
policy adjustment, and if the government is engaged in good faith
efforts with creditors to find a cooperative solution to the country's
payments difficulties. An IMF policy of lending to a country that has
not yet completed negotiations with private creditors, but is
negotiating cooperatively and in good faith, is referred to as ``lending
into arrears.''
A final set of recommended measures would facilitate prompt and
orderly debt workouts. As outlined above, the orderly resolution of
crises will require a combination of official finance, in the context of
strong policy adjustment programs, and appropriate private sector
involvement. Financial crises are often associated with significant
financial distress in the banking and corporate sectors. Although
national insolvency regimes (such as bankruptcy and corporate
restructuring laws) are intended to provide an appropriate legal and
institutional framework for the restructuring of corporate debt,
corporate sector crises may occasionally achieve sufficient scale to
threaten the solvency of a country's entire financial system, as
happened in the Asian crisis.
Several measures can be undertaken to facilitate the orderly workout
of the liabilities of firms in distress. One such measure is available
in domestic insolvency regimes--such as corporate restructuring under
Chapter 11 of the U.S. bankruptcy code--that allow distressed firms to
obtain new, senior credits to ensure their ongoing operation during the
restructuring of their debt. (Seniority means that the new lenders will
be first in line for repayment. Without such assurance, new lenders are
unlikely to come forward.) Analogously, in the international context,
the report suggests that the development of better means of encouraging
the private sector to provide new credits, in the event of a debt crisis
or suspension of debt payments, should be considered. Otherwise, loans
for basic purposes, such as working capital for production and exports,
can become unavailable. In certain circumstances the government may also
find it useful to develop a framework for encouraging out-of-court
negotiations between private debtors and their creditors. International
support can be harnessed to support restructuring efforts as well. For
example, one goal of the Asian Growth and Recovery Initiative, recently
launched by the United States and Japan, is to support the
implementation of more comprehensive and accelerated restructuring of
banks and corporations in the crisis-afflicted countries in Asia.
Implementation of the international financial architectural reforms
proposed in the G-22 reports will take time. But they also promise to
reduce the likelihood of future crises and the severity of those that do
occur. For its part, the G-7 strongly signaled its commitment to
implement many of the reforms proposed by the working groups in its
October 30 declaration, a subject considered next.

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ADOPTION OF MEASURES TO REFORM THE INTERNATIONAL FINANCIAL ARCHITECTURE

The release of the G-22 reports was followed by detailed discussions
among the G-7 finance ministers and central bank governors and with
officials from other industrial and emerging market economies. The G-7
ministers and governors agreed, in a statement issued on October 30,
1998, on specific reforms to strengthen the international financial
system. In the words of their communiqu, they:
agreed to carry these forward through our own actions and in the
appropriate international financial institutions and forums. These
reforms are designed to: increase the transparency and openness of the
international financial system; identify and disseminate international
principles, standards and codes of best practice; strengthen incentives
to meet these international standards; and strengthen official
assistance to help developing countries reinforce their economic and
financial infrastructures. They also include policies and processes to
ensure the stability and improve the surveillance of the international
financial system. Finally, they aim at reforming the International
Financial Institutions, such as the IMF, while deepening cooperation
among industrialized and developing countries.

FURTHER STEPS TO STRENGTHEN THE INTERNATIONAL FINANCIAL ARCHITECTURE

In their October 30 statement, the G-7 countries committed
themselves to a number of reforms consistent with the recommendations of
the G-22 working groups, as well as a great deal of additional analysis
and research. The G-7 also stressed the need for the international
community to widen its efforts to strengthen the international financial
system. The G-7 thus committed themselves to initiate further work in a
number of other important areas to identify additional, concrete steps
to strengthen the international financial architecture. These include:

 examining the additional scope for strengthened prudential
regulation in industrial countries
 further strengthening prudential regulation and financial
systems in emerging markets
 developing new ways to respond to crises, including new
structuresfor official finance and new procedures for greater
private sector involvement in crisis resolution
 assessing proposals for further strengthening of the IMF

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 seeking to minimize the human cost of financial crises and
encouraging the adoption of policies that better protect the
most vulnerable in society
 consideration of the elements necessary for the maintenance of
sustainable exchange rate regimes in emerging markets.

Each of these steps poses a number of issues and challenges. Many
are interrelated. Some of these issues that the international community
will be examining in the future are addressed below.

STRENGTHENED PRUDENTIAL REGULATION AND SUPERVISION IN INDUSTRIAL
COUNTRIES

The crises of the past year have revealed the importance of
strengthening prudential regulation to promote international financial
stability. Global financial integration has led to a proliferation of
financial institutions making cross-border transactions, to the growth
of offshore financial centers and hedge funds, and to the development of
a wide range of derivative instruments. In this new environment,
investors may underestimate the risks they are assuming during periods
of market euphoria, and thus contribute to an excessive buildup of
exposures during the upswing.
Such developments pose significant challenges to financial
regulators and supervisors. Regulatory incentives may be needed to
encourage creditors and investors to act with greater discipline, that
is, to analyze and weigh risks and rewards appropriately in their
lending and investment decisions. Thus, it will be useful to examine the
scope for strengthened prudential regulation and supervision in
industrial countries. Here we explore some aspects of these regulatory
challenges.

Enhanced International Financial Supervision and Surveillance

Traditionally, supervision and regulation of financial systems have
been domestically based. But the increased global integration of
financial markets and the proliferation of institutions doing cross-
border transactions suggest the desirability of enhanced international
financial supervision and surveillance. Better national and
international procedures to monitor and promote stability in the global
financial system might prove useful.
Although good financial supervision still must begin at the domestic
level, international institutions and national authorities involved in
maintaining financial sector stability must work jointly to foster
stability and reduce systemic risk. They will also benefit from
exchanging information more systematically about the risks prevailing in
the international financial system. A useful contribution in this regard
might be a policy-oriented forum including financial authorities from
the G-7 countries, key emerging markets, the IFIs, and other relevant
international organizations.

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Another way to improve global surveillance and coordination might be
to have the IFIs, working closely with international supervisory and
regulatory bodies, conduct surveillance of national financial sectors
and their regulatory and supervisory regimes. For this to succeed, all
relevant information would need to be made accessible to them.

Strengthened Bank Capital Regulation

At the heart of the issue of bank regulation are banks' capital
adequacy standards. As discussed in Chapter 6 (see Box 6-5), banks may
have an incentive to make excessively risky investments, since much of
the cost of failure may be borne by the government. To mitigate this
tendency, banks are required to hold a certain amount of their own
capital in reserve against the loans they make.
The fact that many banks are currently active on a global scale
provides good reasons for common international bank capital standards.
Globally active banks headquartered in countries with low capital
requirements would otherwise be at an advantage over those headquartered
elsewhere. In addition, by virtue of their global scale, the impact of a
global bank's failure would likely extend well beyond the borders of the
country in which it is headquartered.
The 1988 Basle Capital Accord established such an international bank
capital standard by recommending that globally active banks maintain
capital equal to at least 8 percent of their assets. In addition, the
accord sought to distinguish between more and less risky assets and
required that more capital be held against investments with greater
risk. As a result, the 8 percent standard called for in the accord
applies not to a bank's total assets but to its risk-weighted assets.
Safe government bonds or cash, for example, receive a zero weight in
calculating aggregate risk exposure, whereas long-term lending to banks
and industrial companies in emerging markets receives a 100 percent
weight. Such minimum capital standards are meant to work in conjunction
with direct supervision of banks and basic market discipline to restrain
excessive risk taking by banks that have access to the safety net.
Even at the time of their adoption, it was recognized that the
standards called for in the Basle Capital Accord might have to be
reviewed and strengthened in the face of developments in the
international financial environment. Effective capital regulation is an
evolutionary process, and the Basle standards have already been improved
in a number of ways in the decade since their adoption, for example by
the adoption of amendments covering market risk. However, recent
developments have made some shortcomings of the rules for credit risk
more apparent. First, the risk weights applied to broad asset categories
mirror only crudely the actual risk associated with different types of
assets. Second, a number of financial innovations may have made it
easier for banks to assume greater risk without becoming subject to
increased capital charges. Third, the current standards may

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have encouraged banks in industrial countries to make short-term rather
than longer term loans to banks in emerging markets. Fourth, off-
balance-sheet items such as derivative positions, committed credit
lines, and letters of credit may not be adequately addressed by the
current standards. The task of further improving the Basle Capital
Accord has just started. No consensus has yet emerged concerning the
next steps in the reform of bank capital regulation. But it is likely
that a strong and effective system of bank capital regulation will rely
on several complementary components: strengthened capital standards;
improved internal risk management controls in banks, including greater
reliance on banks' own models of risk assessment; and increased reliance
on market discipline.
A broad debate is certain to be waged over how to provide effective
capital regulation of banks in the globalized environment in which they
now operate. The Basle standards were designed for banking institutions
in the G-10 countries, but the proliferation of financial institutions
in emerging markets also poses the question of whether the same
standards adequately address the risks faced by institutions operating
in emerging markets.
The rapid development of derivative instruments and their widespread
use in international financial markets pose another set of difficult
regulatory issues. Derivatives are contracts written in terms of the
price of some underlying asset; for example, stock options and stock
futures contracts are written in terms of stock prices. Derivatives can
be used to hedge risks and thus have been very useful in risk management
by banks, other financial institutions, and nonfinancial firms. However,
they can also be used to take speculative positions, thus increasing
rather than decreasing risk. Moreover, the fact that derivative
positions are recorded off the balance sheet makes it more difficult for
the market and for regulators to assess their contribution to the risks
taken by the institution using them. Also, because the creditworthiness
of the counterparties to a derivatives transaction is not perfect, firms
or banks that believe they are hedged against various risks may
effectively not be.
A difficult issue concerns the type of regulatory oversight that
should be put in place for derivative instruments. For example,
excessive regulation of derivatives could lead the derivatives business
to move to unregulated offshore markets. The President's Working Group
on Financial Markets is undertaking a long-term study of derivative
instruments, including their potential risks and effects. This study
will review recent market developments and existing regulation and
consider what regulatory or legislative changes may be appropriate. It
will investigate possibilities for reducing systemic risk and
eliminating legal uncertainty. It will also assess the potential use of
derivatives for fraud or manipulation, and methods for curtailing
regulatory arbitrage, or the exploitation of differences in regulation
across different jurisdictions.

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Issues Posed by Hedge Funds and Other Highly Leveraged Investment Funds

Another set of difficult regulatory issues is posed by hedge funds
and other highly leveraged entities. Hedge funds in their present form
represent a relatively recent innovation in financial markets. The near-
failure of a prominent hedge fund in September 1998 (see Chapter 2)
focused renewed attention on the role and activities of these and other
highly leveraged entities.
The ``hedge fund'' label is usually applied to investment funds that
are unregulated because they restrict participation to a small number of
wealthy investors (see Chapter 2 for a broader discussion of their
activities). They generally use sophisticated techniques to make
targeted investments. In addition, some of them use significant
leverage--that is, they not only invest their own equity capital but use
sizable amounts of borrowed funds as well. Regulation of hedge funds
could also prove difficult. Poorly designed regulation might, for
example, lead such funds to move to unregulated offshore markets.
The impact of hedge funds and other highly leveraged entities on
financial markets certainly needs to be better understood. Accordingly,
the Secretary of the Treasury has called upon the President's Working
Group on Financial Markets to prepare a study of the potential
implications of the operation of firms such as hedge funds and their
relationships with their creditors. A primary concern for regulators is
to ensure that lenders appropriately manage the risks associated with
extending credit to hedge funds.
The study by the President's working group will examine a number of
issues, including questions relating to the disclosure of information by
entities such as hedge funds and the potential risks associated with
highly leveraged institutions generally. The study will also examine
whether the government needs to do more to discourage excessive
leverage, and if so, what the appropriate steps might be. A number of
the agencies participating in the working group are also involved in
several studies on the international aspects of these questions.

STRENGTHENING PRUDENTIAL REGULATION AND FINANCIAL SYSTEMS AND PROMOTING
ORDERLY CAPITAL ACCOUNT LIBERALIZATION IN EMERGING MARKETS

The Asian crisis has focused attention on a wide variety of
financial policies, both international and domestic in scope.
Considering the central role played by financial sector weaknesses in
the crisis (see Chapter 6), the case for strengthening financial systems
is particularly strong in emerging markets. Accordingly, the second area
in which the G-7 called for further work is the identification of
concrete steps to further strengthen prudential regulation and financial
systems in emerging markets. Clearly, this is an ambitious undertaking
and will require

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a vast number of issues to be considered and challenges to be overcome.
Some of the most significant are addressed below.
Many countries have benefited significantly from the increased
integration of global capital markets. But recent events have shown that
integration, when countries do not have the policies and institutions in
place to capture the full benefits of global integration, can also bring
new risks. The right approach is to put into place the policies and
institutions needed to capture the full benefits of financial
integration.
Remarkably, very few countries have been tempted to turn inward as a
result of the recent crisis. However, instead of facing the challenges
of strengthening their financial institutions, a few have in effect
decided to eschew the benefits of international capital flows by
introducing controls on capital outflows as a way to prevent
``destabilizing'' capital flight. However, many considerations argue
against the use of capital controls in a crisis. First, controls on
outflows are often in practice administered in institutional frameworks
in which they are used to extract economic rents and delay necessary
reforms. Elaborate foreign exchange controls thus lead to corruption,
besides distorting international trade. In any case, investors often
find ways to avoid the controls over time. Moreover, capital controls
may divert attention from the need to address policy distortions that
lead to excessive borrowing, such as inadequate prudential supervision
and regulation of the financial system. Reliance on targeted controls
might eventually also lead countries to use capital controls
indiscriminately, thus insulating unsound macroeconomic policies from
the discipline of the marketplace. Capital controls and other domestic
capital market restrictions also serve as a form of financial
repression--a distortionary type of taxation--that reduces the incentive
to save. Studies show that capital controls in Latin America in the
aftermath of the 1980s debt crisis led to negative real interest rates,
which eventually provoked more flight of capital out of the country
rather than less. Finally, controls on outflows may discourage capital
inflows, since foreign investors will then fear they may not be able to
repatriate the proceeds of their investments in the future. Fears of the
imminent imposition of controls on capital outflows can actually
accelerate rather than avoid or postpone a crisis, and they can lead to
perverse international contagion. For example, news of the imposition of
capital controls in Russia and Malaysia in August 1998 was a factor in
the spread of financial panic to Latin America and other emerging
markets.

The Benefits of Free Capital Mobility

The arguments for free capital mobility are numerous, especially
when domestic financial systems are strong and properly supervised and
regulated. The United States and most other leading industrial
countries, for example, do well without capital controls. First, with
unrestricted capital mobility, the market is free to allocate saving to

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the best investment opportunities, regardless of where in the world
those opportunities are. Investors can then earn a higher rate of return
than they could if limited to the domestic market. Second, firms and
other borrowers in high-growth countries can obtain funds more cheaply
abroad in the absence of controls than if they had to finance their
investments at home. Third, free capital mobility allows investors and
households to diversify risk; access to foreign investment opportunities
enhances the benefits of portfolio diversification. Fourth, the scrutiny
of global investors can provide an important discipline on policymakers.
Well-functioning capital markets can discourage excessive monetary and
fiscal expansion, since inflation, budget deficits, and current account
deficits quickly lead to reserve outflows and currency depreciation.
Logically, a case for restricting capital mobility requires the
identification of distortions in the market allocation of capital.

Increasing the Resilience of Financial Systems

Although introducing controls on outflows is not a desirable
response to a crisis, international capital inflows can reverse
suddenly, and openness potentially does make emerging economies more
vulnerable to such reversals. As a result, policies to increase the
resilience of financial systems might be usefully identified, to make
countries less vulnerable to these crises. These include effective
prudential regulation and supervision of financial markets, as discussed
above. The G-7 has suggested investigating concrete means of encouraging
emerging market economies to adopt international standards and best
practices. In addition, countries could take several steps to reduce the
vulnerability of their financial systems. For example, they can
encourage greater participation in their markets by foreign financial
institutions. They can foster a better credit culture in the banking
system. They can rely more on equity and other financing that does not
result in the buildup of excessive debt burdens. They can implement an
orderly and progressive liberalization of their capital accounts. And in
some circumstances they might find it useful to rely on restraints on
some short-term capital inflows, in the context of sound prudential
regulation of the banking system.

The Orderly Liberalization of Capital Flows

Most emerging market economies have historically placed heavy
restrictions on their capital markets. One result of the recent crisis
is a growing consensus that capital market liberalization has to be
carried out in a careful, orderly, and well-sequenced manner if
countries are to benefit from closer integration into the global
economy. As discussed in Chapter 6, however, if domestic financial
systems are weak, poorly regulated, and subject to institutional
distortions, rapid capital account liberalization can lead to excessive
short-term borrowing and lending and a mismatch of maturities and
currency denominations in the

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assets and liabilities of both financial institutions and nonfinancial
firms. To reduce the risk of financial and currency crises following
liberalization, effective regulatory and supervisory regimes must be in
place, and the financial sector must be poised to deal adequately with
these risks.
It may prove useful to develop principles to help guide countries
that are liberalizing and opening their capital markets, to help reduce
the vulnerability of their financial systems to sudden shifts in capital
flows. Possible measures include, for example, a policy of openness to
foreign direct investment and promotion of longer term equity financing.
Conversely, some support consideration of measures to restrain cross-
border short-term interbank flows into emerging markets, because such
flows are likely to be both volatile and vulnerable to distortions
arising from financial safety nets.

Prudential Regulation of Short-Term Interbank Cross-Border Inflows

One approach to ensuring the stability of short-term interbank flows
is through enhanced prudential banking standards. On the borrower side,
a range of possible measures could be considered to help discourage
imprudent foreign currency borrowing, while relying on market mechanisms
to the extent possible. Prudential bank standards, such as limits on a
bank's open foreign currency positions, if enforced effectively, could
reduce the riskier kinds of foreign borrowing by banks. Some countries
have experimented with regulatory requirements that force their banking
systems to maintain ``liquidity buffers'' to protect against the risk of
sudden shifts in funds out of the banking system. Argentina, for
example, has required banks to maintain large, liquid reserves against
their short-term liabilities, including their short-term foreign
liabilities.
Greater prudence in the use of short-term, cross-border interbank
flows could also be encouraged on the lender side. This could be
accomplished through prudential regulation of the international short-
term lending of banks in the industrial countries, so as to encourage
more careful lending to emerging market entities that operate in weak
financial systems.

Should There Be Broader Controls on All Short-Term Capital Inflows?

More controversially, some have suggested wider use of market-based
restraints on all short-term capital inflows, to deter short-term
foreign borrowing not just through banks but by other means as well.
Chile is one country that has taken this approach. In some countries,
nonfinancial firms are reported to have undertaken large-scale risky
cross-border borrowing directly, rather than via the banking system, in
the leadup to the crisis in Asia, for example. It has been argued that

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regulation of inflows to banks alone would lead to evasion through
direct cross-border borrowing by nonfinancial firms. It has also been
argued that taxes on general inflows may help in the management of
monetary policy when surges in inflows create difficult problems, such
as how to ``sterilize'' their impact and avoid an inflationary surge in
the money supply.
The effectiveness of such controls has been questioned, however.
Evasion and leakages tend to make capital controls less effective over
time. Also, the apparent success of Chile may have been due more to that
country's very effective prudential regulation and supervision of its
financial system and fairly sound macroeconomic policies than to capital
controls. Finally, such controls have tended to favor large corporations
(which are more capable of raising funds directly in international
financial markets) at the expense of small and medium-size ones.
The available empirical evidence from countries that have imposed
controls on a broad range of short-term capital inflows shows that they
do appear to have affected the composition of inflows. Controls have
steered inflows away from instruments of short-term maturity and toward
longer term instruments and foreign direct investment. They do not
appear to have affected the overall volume of capital inflows. Opponents
of controls point out that, during the recent financial turmoil, Chile,
Colombia, and Brazil have all reduced their controls in order to
stimulate urgently needed capital inflows and reduce pressures against
their currencies. Proponents reply that these moves do not undermine the
rationale for controls. Their purpose is to slow down short-term capital
inflows temporarily during a cyclical phase where such inflows are
feared to be excessive. In the outflow phase of the cycle (and
especially in time of crisis), it is argued that it is sensible, and not
inconsistent, to remove the controls. Evidence on the appropriateness of
Chilean-style controls is not only mixed but preliminary and based on
the experience of a limited set of countries. Given the numerous
arguments on both sides, policies to restrict all short-term inflows
remain quite controversial.
Alongside the policies needed to strengthen financial systems, a
number of other policies are beneficial in developing countries to
enhance financial stability, foster long-term economic growth, and limit
their vulnerability to shifts in global capital. Countries need sound
and consistent monetary and exchange rate policies, as well as fiscal
policies that avoid excessive accumulation of government debt. Although
short-term and foreign currency borrowing can be very appealing to a
government, because it is cheaper and often easier in the short run than
borrowing long term and in local currency, too much of this kind of
borrowing makes countries vulnerable to sudden shifts in investor
confidence. Sound public debt management is important to insure against
the risk of market disruptions.

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DEVELOPING NEW APPROACHES TO CRISIS RESPONSE

Any regime designed to respond to international financial crises
must provide some combination of external financial assistance and
domestic policy changes. The provision of large-scale official
international finance raises difficult questions concerning the criteria
that should govern access to such assistance, the appropriate terms, the
links (if any) to private sector involvement, and the sources of
funding. Reform of the present regime also requires the consideration of
new procedures for coordinating the relevant international bodies and
national authorities, alongside greater participation by the private
sector in crisis prevention and resolution.

New Structures for Official Finance

The recent global financial turmoil points to the usefulness of
developing new ways for the international community to respond to
crises. This entails exploring the possibilities of new structures for
official finance that better reflect the evolution of modern markets. In
their October 30 declaration the G-7 agreed that, in response to the
current exceptional circumstances in the international capital markets,
strengthened arrangements for dealing with contagion will be beneficial.
They called for the establishment of an enhanced IMF facility that would
provide a contingent short-term line of credit for countries pursuing
strong IMF-approved policies --that is, those cases where problems stem
more from contagion than from poor policies. This would be a departure
from traditional IMF packages, which are disbursed in a series of
stages, or tranches, to encourage borrowers to adhere to strict policy
conditionality. This facility could be drawn upon in time of need and
would entail appropriate interest rates along with shorter maturities.
The facility would be accompanied by appropriate private sector
involvement.
The rationale for a precautionary facility is that countries with
sound economic policies may be subject to attack because of contagion.
The international community has a role to play in international
financial crises, by intervening, when appropriate, to help limit
contagion and global instability. It may make sense in today's world of
large and sudden liquidity needs for more official money to be made
available up front in return for policy changes that are likewise more
up front. The Congress' agreement in 1998 to support an increase in the
IMF quota will provide the IMF with an important pool of new,
uncommitted funds. The U.S. contribution that Congressional action made
possible will be strongly leveraged through the contributions of the
other IMF members.

The Continued Need for Greater Private Sector Participation

As described earlier in this chapter, the G-22 working group report
on international financial crises pointed to the need for future work to
develop new procedures for orderly and cooperative crisis resolution, to

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complement the role of official finance. The G-7 has called for similar
work as part of the next steps identified in its October 30 Declaration.
The size, sophistication, and heterogeneity of recent international
capital flows have reduced the relevance of the procedures used in the
past when the private sector was involved in the resolution of severe
international financial crises. These procedures were developed during
an era when a small number of large international banks were the source
of most capital flows to emerging markets. There is now a need to
develop innovative ways for holders of new financial instruments to
participate constructively in crisis containment and resolution. Also,
innovative financing techniques, such as prenegotiated contingent lines
of credit and financial provisions that provide greater explicit sharing
of risk between creditors and debtors, are two avenues, among others,
worthy of exploration.

STRENGTHENING THE IMF

With the IMF's resources recently augmented, the institution's
members need to be sure that its policies effectively address the new
challenges of the global economy, and to provide the necessary political
oversight and guidance to accomplish this objective. An enhanced IMF
facility to provide a contingent line of credit, as discussed above,
would constitute a significant adaptation and strengthening of the IMF's
policies for crisis prevention and resolution to reflect the evolution
of the global economy. Another area where policies could be strengthened
is in the concerted use of periodic reviews of members' economies, to
promote greater transparency of policies and compliance with standards
or other expressions of best practice in areas relevant to the effective
conduct of economic policy. One aspect of transparency of particular
importance concerns encouraging the publication, by those countries that
rely on global capital markets, of key economic data as set forth in the
Special Data Dissemination Standard, which has been in effect on a
voluntary basis since 1996. The IMF's own transparency could also be
further improved by such steps as more widespread public release of
information on the policy deliberations of the IMF's Executive Board.
This could be accomplished along the lines of the procedures for the
IMF's periodic reviews, mentioned above, whereby the country under
review may assent to a press release. In all these areas, the IMF will
need to ensure that its work continues, as warranted, to be closely
coordinated with other international entities, such as the World Bank.
It will also be important to ensure that the IMF's Interim
Committee, as the body designed to provide ministerial-level guidance to
the work of the IMF on a regular basis, is able to continue to provide
effective political-level oversight and direction of the IMF in a manner
that reflects the evolving nature of the challenges of the international
financial system. Consideration of proposals to achieve this objective

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is in progress. Any changes adopted will need to be consistent with the
parallel objective of strengthening the World Bank's Development
Committee, which is the comparable entity for that organization.

MINIMIZING THE HUMAN COSTS OF FINANCIAL CRISES

The sharp recessions in East Asia have led to a steep increase in
both unemployment and poverty in that part of the world, inflicting
severe social costs. More attention must be given in time of crisis to
the effect of economic adjustment on the most vulnerable groups in
society. Thus, strengthening social safety nets in crisis countries is
also an important goal of stabilization packages. Ways must be found to
minimize the human cost of financial crises and encourage the adoption
of policies that better protect the most vulnerable in society. Just as
important, countries should be encouraged to establish minimal social
services for their populations, so as to be prepared to weather
financial crises and other such shocks.
The Administration has been working with the world's multilateral
development banks (MDBs; these include the World Bank and the regional
development banks) to provide increased social safety nets in the
countries in crisis, to help the least advantaged citizens in those
countries who are experiencing hardship. The G-7 have asked the World
Bank to develop, in consultation with other relevant institutions,
general principles of good practice in social policy. These should then
be drawn upon in developing adjustment programs in response to crises.
The World Bank and the regional MDBs are well positioned to provide
adequate spending in the areas of health and education--two of the most
crucial areas in which the MDBs should focus their resources. Plans for
employment creation, support for small and medium-size enterprises, and
support in the development of unemployment insurance and pension plans
are needed as well.

SUSTAINABLE EXCHANGE RATE REGIMES FOR EMERGING MARKETS

Exchange rate regimes are institutional choices that signal
policies, priorities, and commitments. They vary in their rigidity. The
choices go beyond fixed versus floating rates. They range from
institutional arrangements like monetary unions, dollarized regimes, and
currency boards to conventional fixed exchange rates, crawling pegs,
basket pegs, managed floats, and free floats. No single exchange rate
regime is best for all countries at all times; rather the choice must be
based on a country's circumstances.
The choice of an appropriate exchange rate regime for emerging
market economies is particularly difficult, given that many emerging
markets have extensive trading ties to a number of major industrial
economies, and that the credibility of the policy environment in many

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emerging markets will take time to establish. No matter what exchange
rate regime a country chooses, it is critical that it be backed by
strong financial regulation and appropriate monetary and fiscal
policies. Macroeconomic stability is based on good policies,
irrespective of the exchange rate regime. Policy mistakes that
contribute to a currency crisis can occur under any exchange rate
regime.
The three goals of financial market openness, monetary policy
independence, and exchange rate stability are not conceptually
consistent--indeed, these goals are sometimes called the ``impossible
trinity.'' There are tradeoffs among these goals: a country can attain
any two out of the three, but not all three; it must give up at least
one. As we have seen, most countries have moved in the direction of
increasingly open capital markets. For them the choice narrows to the
other two goals. With perfect capital mobility, a country choosing a
fixed exchange rate loses its ability to pursue an independent monetary
policy; conversely, an autonomous monetary policy can be pursued only if
the exchange rate is allowed to move flexibly. Therefore, a choice must
be made between exchange rate fixity and monetary policy autonomy if
free capital mobility is to be maintained.

Benefits of Fixed Exchange Rate Regimes

Why would a country choose to fix its exchange rate, if it must give
up a large part of its monetary independence to do so? There are a
variety of reasons. One is that by eliminating exchange rate risk, a
fixed exchange rate regime may encourage international trade and
finance. However, the evidence on the effects of exchange rate stability
on trade volumes is mixed. The effects on trade and finance may be
greater if a country goes beyond fixing its exchange rate and simply
adopts the currency of another country, through monetary union or
dollarization.
Another potential benefit of fixed rate regimes is that they can
foster monetary discipline. The loss of monetary autonomy under fixed
exchange rates limits the ability of monetary authorities to pursue
excessively expansionary and inflationary monetary policies. Thus, such
a regime can be an important signal of policy commitment to achieving
and maintaining low inflation, especially when countries are seeking a
rapid retreat from conditions of high inflation or hyperinflation, as
part of a consistent plan for macroeconomic stability.
By reducing the ability of monetary authorities to monetize fiscal
deficits, a fixed rate regime may also restrain tendencies toward loose
fiscal policy. Adopting a fixed exchange rate does not, however,
automatically instill policy discipline. Rather, a fixed exchange rate
regime or a currency board requires fiscal discipline and a strong
financial system to be credible. (A currency board is a particularly
rigid variety of fixed rate regime that issues only as much domestic
currency as is backed by foreign exchange reserves; see Box 7-1 for a
discussion.)

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Box 7-1.--Currency Boards

A currency board is a monetary institution that only issues
currency to the extent it is fully backed by foreign assets. Its
principal attributes include the following:
 an exchange rate that is fixed not just by policy, but by
law
 a reserve requirement stipulating that each dollar's worth
of domestic currency is backed by a dollar's worth of reserves in a
chosen anchor currency, and
 a self-correcting balance of payments mechanism, in which a
payments deficit automatically contracts the money supply, resulting in
a contraction of spending.
By maintaining a strictly unyielding exchange rate and 100 percent
reserves, a government that opts for a currency board hopes to ensure
credibility.
The first currency board was established in Mauritius, at that
time a colony of Great Britain, in 1849. The use of currency boards
eventually spread to 70 British colonies. Their purpose was to provide
the colonies with a stable currency while avoiding the difficulty of
issuing sterling notes and coins, which were costly to replace if lost
or destroyed. The colonies also benefited from this arrangement in that
they could earn interest on the foreign currency assets being held in
reserve. The use of currency boards peaked in the 1940s and declined
thereafter. In the 1960s, many newly independent African countries
replaced their currency boards with central banks, and most other
countries followed suit in the 1970s.
The introduction of currency board-like arrangements in Hong Kong
(1983), Argentina (1991), Estonia (1992), Lithuania (1994), and Bulgaria
(1997) constitutes a small resurgence in their use worldwide. A currency
board can help lend credibility to the policy environment by depriving
the monetary authorities of the option of printing money to finance
government deficits. Argentina, for example, has benefited from the
credibility inspired by its currency board regime. Argentina was
prompted to adopt such a regime, which it calls the Convertibility Plan,
because of a dramatic hyperinflation in the 1980s and the absence of a
credible monetary authority. Since 1991 the country has become a model
of price stability and has achieved laudable growth rates, except during
the recession brought on by the tequila crisis in 1995, from which it
has rebounded. By most accounts, the currency board has worked for
Argentina.
Characteristics that suit countries to be candidates for currency
boards are the following: a small, open economy; a desire for further
close integration with a particular neighbor or trading

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Box 7-1.--continued

partner; a strong need to import monetary stability, because of a
history of hyperinflation or an absence of credible public institutions;
access to adequate foreign exchange reserves; and a strong, well-
supervised, and well-regulated financial system. Advocates of currency
boards have pushed for their wider use--in particular, for Indonesia,
Russia, and Ukraine. However, proclaiming a currency board does not
automatically guarantee the credibility of the fixed rate peg. A
currency board is unlikely to be successful without the solid
fundamentals of adequate reserves, fiscal discipline, and a strong and
well-supervised financial system, in addition to the rule of law.

Benefits of Exchange Rate Flexibility

Exchange rate flexibility offers several benefits. Most succinctly,
as already noted, it allows greater monetary independence. Flexible
exchange rate regimes allow a country to pursue a different monetary
policy from that of its neighbors, as it might want to do, for example,
when it is at a different stage of its business cycle. In addition, a
flexible rate regime can facilitate a country's adjustment to external
shocks, such as the swings in capital flows and the terms-of-trade
shocks that have been factors in recent crises. Finally, flexible
exchange rates make the risk of foreign currency-denominated borrowing
by banks and firms explicit. This may help discourage the accumulation
of unhedged foreign currency liabilities.
Many episodes of currency crisis in the 1990s, discussed in Chapter
6, occurred under regimes where exchange rates were either fixed or kept
in a narrow band. Semi-fixed exchange rate regimes and policies of
exchange rate-based stabilization have at times led to real currency
appreciations that worsened a current account deficit and helped trigger
a crisis. Maintaining fixed rates long into the aftermath of an exchange
rate-based stabilization can lead to a real appreciation (due to
residual inflation) and a deteriorating trade balance, which can
eventually undermine the fixed rate regime if it is not supported by
consistent policy regimes. Some countries have made strong institutional
commitments to a rigidly fixed regime; others could benefit from
increasing flexibility during periods of macroeconomic and financial
stability, when the move to flexibility may be less disruptive.
One form of fixed exchange rates that is even more extreme than a
currency board is a monetary union, which solves the problems of
credibility and speculation automatically. The next section discusses
the prospects of European Monetary Union and whether Europe represents
an ``optimum currency area.''

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EUROPEAN ECONOMIC AND MONETARY UNION

The European response during the 1990s to the challenges presented
by financial globalization has been to continue the process of economic
and financial integration of the continent. As part of this process, 11
members of the European Union embarked on a project of monetary
unification, which took effect on January 1, 1999, with the third stage
of European Economic and Monetary Union (EMU). European integration
raises some of the same analytical issues and policy challenges as the
integration of the emerging market countries into the world financial
system.

THE EMU SCHEDULE

In a summit meeting in the spring of 1998, the heads of the EU
governments decided that EMU should proceed as envisioned in the
Maastricht Treaty of 1991 to its third stage, monetary unification. The
founding members of EMU were selected on the basis of assessments, made
by the European Monetary Institute (the forerunner of the European
Central Bank) and the European Commission, as to whether they had met
the Maastricht Treaty's economic convergence criteria in 1997. Members
were required to have had government deficits and total debt that were
no greater than 3 percent and 60 percent of gross domestic product
(GDP), respectively. In addition, their inflation rates and long-term
interest rates had to have been within 1.5 and 2 percentage points,
respectively, of the average of the three EU countries with the lowest
inflation and interest rates. Finally, members' currencies must also
have stayed within the EU Exchange Rate Mechanism bands for 2 years.
Twelve of the 15 EU members wished to participate in EMU from its
inception, and 11 of these were found to satisfy the criteria (only
Greece was not). This, in part, reflected remarkable progress toward
fiscal consolidation, since the targets had seemed out of reach for
members such as Italy a mere year or two before. Of the other three EU
countries, Denmark and the United Kingdom had opted not to join EMU for
the time being, whereas Sweden had chosen not to qualify by remaining
out of the Exchange Rate Mechanism.
The remarkable convergence of financial conditions in the European
countries is clear from data on the 11 EMU countries' short-term and
long-term interest rates (Charts 7-1 and 7-2), which show a sharp
convergence after 1996. Differences in interest rates across countries
can be due to two major factors: a currency premium related to the risk
of devaluation, and a country premium related to the possibility of
default on the public debt. With monetary union to start in January
1999, short-term interest rates had converged by late 1998, as currency
risk was eliminated (default risk is already close to zero for very

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short-term public debt). Even after monetary union, differences among
long-term interest rates may remain, as different EMU countries with
different stocks of public debt may be perceived as having different
default probabilities. However, long-term interest rates among the 11
countries (collectively called the euro-11 area) had converged quite
sharply by the fall of 1998 as well.
In July 1998 the European Central Bank came into existence. On
January 1, 1999, a single currency, the euro, was created as the
currency of the 11 EMU countries. On the same date the European Central
Bank took control of monetary policy in these countries. Existing
national notes and coins will continue to circulate until euro cash is
introduced, but the mark, the franc, the lira, and the rest are no
longer separate currencies. Rather they are ``nondecimal denominations''
of the euro, locked in to it at permanent conversion rates. (By analogy,
U.S. dollar bills are issued in the 12 Federal Reserve districts around
the country and carry a circular seal with a letter inside denoting the
district from which they come. However, Europeans will continue for some
time to be far more aware of the geographic origin of the currency they
carry than Americans are.) Only in 2002 will euro cash enter into
circulation and national currencies be phased out. This transition
period is necessary because authorities need time to print the banknotes
and mint coins. Retailers and banks also want time to prepare, and
governments have to consider how to change their services over to the
use of the euro.
Although euro cash will be introduced only in 2002, many changes
will occur in the 3 years between now and then. Government bonds issued
after 1999 will be denominated in euros. Almost all outstanding issues
of marketable government debt by the participating countries were
redenominated in euros at the end of 1998. Moreover, several large
European companies plan to begin accounting in euros in 1999. Such a
move may lead smaller firms to follow. Even businesses that do not
switch their internal accounting to euros may quote prices in euros for
trading before 2002. Consumers and the public sector are likely to be
using national currency units until 2002. In general, European
governments agreed that there will be no compulsion and no prohibition
in the use of the euro between 1999 and 2002.

THE BENEFITS AND POTENTIAL COSTS OF EMU

EMU offers several potential benefits. Transactions costs in trade
among the members will be lowered, as exchange rate risk and currency
transactions within Europe will both be eliminated; the ensuing goods
market integration and enhanced price competition will be beneficial to
consumers. Integrated European financial markets will be broadened and
deepened. Price discipline will be preserved by the independent European
Central Bank, which is committed to price stability. It is hoped that
fiscal discipline will also result, since, as the

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members agreed in a separate Growth and Stability Pact, membership
requires maintenance of a disciplined fiscal policy. (According to the
pact, fines may be imposed on countries found to be running excessive
deficits.) Participation in EMU thus eliminates national monetary policy
and limits the scope of fiscal policy as a stabilization tool. This loss
of macroeconomic tools to address cyclical unemployment makes more
urgent the need for European structural reforms, for example to increase
flexibility in the labor market. In this sense it is hoped that EMU
might serve as discipline to nudge European countries to implement
structural reforms more rapidly and eliminate impediments to sustained
growth.
The creation of a large region of monetary stability is a
commendable culmination of the 50-year process of economic, social, and
political integration that has taken place in Europe. Indeed, the
original motivation for economic integration in Europe was to ensure
that the countries in the heart of Europe, which had fought three major
wars over the preceding 100 years, never do so again. This is one reason
why, in historical perspective, European integration has always been in
the political interest of the United States. But the United States will
also benefit in an economic sense, as a trading partner with Europe,
from strong economic performance there, which the single-currency
project may enhance in the long run. As long as Europe remains open to
trade, what is good for Europe economically is good for Americans.
However, EMU also entails some potential costs. Most important, the
loss of monetary autonomy deprives countries of a tool to respond to
asymmetric national shocks --unexpected economic developments that
affect some countries differently than others. Similarly, exchange rate
changes are another instrument for coping with such shocks, but with EMU
this tool will also no longer be available. Without these tools,
flexibility of wages and labor mobility across regions and industries
are the major mechanisms of adjustment. But labor mobility is much lower
among the nations of Europe than, for example, among the American
States. Fiscal policy can also play a stabilization role, but again, the
rules for EMU membership constrain countries' ability to use that tool.
Finally, Europe also lacks a centralized system of taxes and transfers
comparable to that of the United States to cushion against regional and
national shocks. Limited labor mobility, structural labor market
rigidities, and decentralized and constrained fiscal policies could
imply that Europe does not satisfy the criteria for an optimum currency
area (Box 7-2) as clearly as do the States of the United States.
Although these potential costs of EMU have some relevance, some of
the objections to EMU have been exaggerated. For example, although
monetary policy is a potent policy tool for mitigating cyclical
unemployment (that caused by shocks affecting aggregate demand for a
country's goods and services), it has little long-run impact on

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Box 7-2.--Is Europe an Optimum Currency Area?

The theory of optimum currency areas provides a set of criteria by
which to identify groups of countries that are likely to benefit from
membership in a common monetary union. Some research suggests that the
nations of the European Union are less well suited to a common currency
than are, for example, the States of the United States. Yet Europe is
becoming increasingly integrated over time, and this may tip the balance
in the direction of satisfying these criteria in the future.
Common rather than national shocks. Why do countries ever need
independent currencies? If a country (or other geographic region)
suffers an adverse shock, such as a fall in demand for its products, it
may want to follow a more expansionary monetary policy, to stimulate
demand and head off unemployment. Yet it cannot do so if it does not
have an independent currency. Conversely, only common shocks can be
properly addressed by a unionwide change in monetary policy.
For example, in the early 1990s Germany experienced a sudden
increase in interest rates, as a result of unification, which led to an
increase in western German spending in the eastern lnder. It
was difficult for other European countries to accept this increase in
German interest rates, because it did not suit their own economic
conditions. The resultant strains broke apart Europe's Exchange Rate
Mechanism in 1992-93, although it was later restored.
A high degree of labor mobility. Labor mobility is an important
criterion for an optimum currency area: a region that has this means of
adjustment available has less need for monetary independence. In the
event of an adverse shock in one country, workers can simply move to
other countries or regions with stronger economies. Although this might
not appear to be an attractive solution, it turns out that interstate
migration is the most rapid means of adjustment (more rapid than changes
in wage levels, for example) to economic downturns within the United
States. Labor mobility among the European countries is much lower than
in the United States. Thus, by the labor mobility criterion, European
countries are less well suited to a common currency than are the
American States.
The existence of a federal system of fiscal transfers. When
disparities in income do arise in the United States, Federal fiscal
policy helps narrow them. One recent estimate suggests that when a
region's income per capita falls by $1, the final reduction in its
disposable income is only 70 cents. The difference, a 30 percent Federal
cushioning effect, comes about both through an automatic decrease in
Federal tax receipts and

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Box 7-2.--continued

through an automatic increase in unemployment compensation and other
transfers. The cushioning effect has been estimated at a lower 17
percent in the case of the Canadian provinces. European countries have
greater scope for domestic fiscal stabilization than do American States.
There are also some cross-country fiscal transfer mechanisms. But
neither the fiscal transfer mechanisms already in place within the
European Union nor those contemplated under EMU (the so-called cohesion
funds) are as large as those in the U.S. or the Canadian fiscal system.
At least by the theoretical criteria of labor mobility and
availability of fiscal transfers, then, the European Union is not as
good a candidate for a monetary union as the United States. European
countries may be less adaptable to adverse shocks than American States.
This suggests that, if shocks occur in the coming decade that affect EU
members as differently as did the German unification shock of the early
1990s, governments in those countries adversely affected could
experience popular resentment against what for them will be the
insufficiently expansionary monetary policies of the rest.
The prospects for EMU. There is good hope, however, for a
successful EMU. The degree of integration among the EU countries is
increasing decade by decade. International labor mobility, for example,
is likely to be higher in the future than in the past. The Schengen
convention now allows free movement of citizens among a subset of
European countries. Thus, the European countries may come to satisfy the
textbook criteria of an optimum currency area in the future, even if
they do not do so fully now.
unemployment caused by such structural rigidities as labor market
inflexibility or real wage rigidity. Such conditions result in high
levels of the full-employment unemployment rate (the lowest rate of
unemployment consistent with stable inflation--also called the
nonaccelerating-inflation rate of unemployment, or NAIRU) in many
European countries and in such chronically depressed regions as southern
Italy. These problems must be addressed through structural reform, with
or without monetary union.
Second, the scope for fiscal expansion is also limited in Europe,
because fiscal deficits and debt-to-GDP ratios remain high in a number
of countries. Fiscal consolidation must therefore continue with or
without EMU; in this sense, EMU may not be a strong constraint.

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Third, asymmetric shocks and limited factor mobility may diminish
over time as EMU itself leads to greater real integration among the
European economies (see Box 7-2). For example, as intra-European trade
continues to grow in response to European integration and EMU, the
creation of a common free market for goods, services, and factors of
production could make idiosyncratic national shocks less prevalent, if
it reduces the geographical concentration of industries in certain
countries.
Finally, it has been argued that EMU is likely to exert discipline
in favor of structural reform. As there will be no national monetary and
exchange rate policies, and fiscal policy autonomy will be constrained,
the ability to use instruments of macroeconomic policy to delay
structural market reforms will be reduced; governments will then have
stronger incentives to pursue policies that further long-run economic
growth. Critics of this view contend, however, that EMU could actually
slow the drive for structural reforms: because reforms are socially
costly, the flexibility deriving from monetary, exchange rate, and
fiscal discretion could ease the transition costs as resources are
reallocated. With EMU, the absence of these social shock absorbers may
slow structural reform.

THE EURO AS AN INTERNATIONAL CURRENCY AND THE IMPLICATIONS FOR THE
DOLLAR

Monetary union in Europe is a positive development that could
simultaneously benefit the continent itself, the United States, and the
world economy. Some have expressed concern, however, that a strong
European economy and the emergence of the euro as an alternative
international currency, rivaling the dollar, are likely to harm the
United States. Such concerns are largely misguided. The United States
has long benefited from a prosperous, growing Europe, and ever since the
Marshall Plan, U.S. policy has supported the development of strong
market economies on that continent. The United States will benefit from
an open and integrated economic area in Europe. American producers will
be able to export to a large, integrated European market with no cross-
national restrictions on trade. U.S. firms producing in Europe will
benefit from the lack of exchange rate volatility, common standards for
goods and services, and a large, open market. Indeed, U.S. corporations
have more experience selling into a large, unified market than do their
European counterparts. American financial institutions, in particular,
are already quite competitive in commercial and investment banking
services and securities products and can benefit from the opportunities
provided by the broadening and deepening of integrated European
financial markets.
The emergence of the euro as an international currency should not be
viewed with alarm, for a number of reasons. Even if the euro emerges as
a strong international currency, the negative effects on U.S. economic
welfare are likely to be small and outweighed by the

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advantages of EMU to U.S. residents, as already described. And in any
case the euro is unlikely to rapidly displace the dollar as a major
international currency, given that the foundations of the successful
performance of the U.S. economy remain intact. International currency
status does not automatically follow from a currency's possession of a
large home base.

The Functions of an International Currency

What does it mean to be a major international currency, and is it
likely that the euro will become one? A currency has three main uses: it
can be used as a means of payment, as a unit of account, and as a store
of value. An international currency is simply one that is also used
outside its home country for these three purposes. Within each of the
three functions, an international currency has both official and private
uses.
In money's store-of-value function, investors decide how much of
their wealth to hold in the form of assets denominated in various
currencies. Will public and private investors hold a fraction of their
portfolios in assets denominated in euros? If they hold a fraction that
exceeds the sum of the fractions previously occupied by the German mark
and the other disappearing European currencies, a portfolio shift would
occur, leading to greater demand for euros. This, in turn, could cause
an appreciation of the euro. However, whether euro-denominated assets do
acquire a higher share of portfolios will depend on various economic
factors. These include the inflation rate in the euro area, confidence
in the value of the euro relative to the dollar and the yen, the rate of
return on euro-denominated assets, and economic growth in Europe, as
well as political factors.
The official side of the store-of-value use is that central banks
hold currencies as foreign reserves. The euro's emergence raises the
possibility of greater diversification of these reserves away from the
dollar toward the euro. In the 1970s and 1980s, the dollar's share of
reserve currency holdings gradually shrank to make room for the mark and
the yen. This trend was suspended, or even reversed, in the 1990s. But
it could resume in the 2000s to make room for the euro. Such
diversification away from the dollar would depend in part on the same
risk-reward considerations as matter for private use. Countries with
strong economic fundamentals, sound currencies, and low inflation are
more likely to have their currency used as an international currency. As
long as the United States maintains a strong economy, international
demand for dollars will remain strong.
A unit of account is a reference scale for quoting prices, which is
distinguishable from the actual currency in which assets are held or
payments made. For the private sector an international currency
functions as a unit of account through its use in invoicing imports and
exports. Presently, the dollar plays a dominant role in invoicing around
the world, especially for primary commodities like oil. Invoicing within
Western

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Europe will henceforth be mostly in euros, but the euro may also come to
be used even more widely in Central and Eastern Europe, the Middle East,
and Africa, areas of substantial and increasing trade with Europe.
One official use of international currencies that can be classified
under the unit-of-account function is as a major currency to which
smaller countries can peg their exchange rates. Non-EMU European
countries, particularly those in Central and Eastern Europe, are likely
to consider pegging their currencies to the euro for two reasons:
because they undertake more of their trade and finance with the EU
countries than with the United States, and because they aspire to
eventual membership in EMU. If this happens, greater use of the euro by
these countries as an intervention currency will increase official
demand for euros. The unit-of-account, store-of-value, and means-of-
payment functions are thus interrelated.
Currently, the dollar is the primary vehicle currency in foreign
exchange trading, which is one example of the use of a currency as a
means of payment. A trader who wishes to exchange one minor currency for
another usually has to exchange the first currency for one of the major
currencies, and then exchange that currency for the currency he or she
ultimately wants to buy. Traders today are more likely to use the dollar
as the intermediate, or vehicle, currency than to go through some other
major currency or to be able to find a counterparty for a direct cross
trade. (See Box 7-3 on the role of different international vehicle
currencies.)
The use of a currency by the private sector as a means of payment in
international trade and finance depends on economies of scale in
payments systems. As in the case of a domestic currency, increasing
returns to scale in payments are significant: it is easier and cheaper
to use the same currency that everyone else uses. In this regard the
advantages of incumbency and inertia favor the dollar even as the euro's
natural home grows to be as large as that of the dollar.
In short, although it is likely that the euro will become an
international currency, it is unlikely that the dollar will be replaced
anytime soon in its role as the leading international currency.

Is it Good or Bad to Be an International Currency?

Does it matter whether the dollar remains the leading international
currency? One should not overemphasize the decidedly modest benefits
that having an international currency provides to a country.
Advantages of having a key currency. At least five advantages accrue
to a country from having its currency used internationally. The first is
convenience for the country's residents. It is certainly more convenient
for a country's exporters, importers, borrowers, and lenders to be able
to deal in their own currency rather than in foreign currencies. The
global use of the dollar, like the increasingly global use of the
English language, is a natural advantage that American businesses may
take

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Box 7-3.--How Does the Dollar Rank Today Against Other International
Currencies?

Most measures show a gradual decline in international use of the
dollar in recent decades. Reserve currency use, perhaps the best
measure, is shown in Chart 7-3. The dollar's share of central bank
reserve holdings declined from 76 percent in 1973 to 49 percent in 1990.
This reflects a gradual shift of central bank portfolio shares into
marks and yen. However, the dollar's share in reserve holdings has been
relatively flat in the 1990s, amounting to 57 percent in 1997.
Other major measures of international currency status, as of the
eve of the birth of the euro, are shown in Table 7-1. They tend to
present the same picture: the dollar still leads, despite a gradual
decline in its use versus the mark and the yen over the last 30 years.
The dollar is still more important than its three or four closest rivals
combined.
The first column in Table 7-1 reports the popularity of major
currencies among smaller countries choosing a peg for their currencies.
The dollar is the choice of 39 percent of these countries. Three
currencies (those of Bosnia, Bulgaria, and Estonia) were pegged to the
mark last year, however. Elsewhere, the French franc was, after the
dollar, still the most common choice as a peg, accounting for 29 percent
of countries using pegs; these countries are principally in Africa,
owing to a special set of arrangements with the French treasury. The
euro is inheriting this role of the mark and the franc. It is still the
case that no currencies anywhere are pegged to the yen. The dollar was
the currency either bought or sold in fully 87 percent of trades in
global foreign exchange markets in April 1998 . This figure (like the
share of reserves held in dollars) should automatically go up in 1999,
as EMU eliminates intra-European transactions among member currencies.
The various measures of the use of currencies to denominate
private international financial transactions--loans, bonds, and
deposits--also still showed the dollar as the dominant currency, with a
54 percent share.
Figures on the use of international currencies as substitutes in
local cash transactions are not generally available. According to
estimates, however, the leader has been the dollar, for which
internationally circulating cash has been estimated by the Federal
Reserve at 60 percent of currency outstanding. International circulation
of the mark has been estimated by the Bundesbank (Germany's central
bank) at 35 to 40 percent of the German currency outstanding, but
because the outstanding stock of marks is much smaller than that of
dollars, the mark's share of total currency in international circulation
is smaller than this figure would suggest.

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for granted. But the benefits from having one's country's currency used
as a unit of account should not be overemphasized. Invoicing U.S.
imports in dollars does not necessarily shift the currency risk from the
buyer to the seller, as the dollar price sometimes can change quickly
when the exchange rate changes.
A second possible advantage is increased business for the country's
banks and other financial institutions. However, there need be no firm

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connection between the currency in which banking is conducted and the
nationality of the banks conducting it (or between the nationalities of
savers and borrowers and the nationality of the intermediating bank).
British banks, for example, continued to do well in the Eurodollar
market long after the pound's international role had waned.
Nevertheless, it stands to reason that U.S. banks have comparative
advantage in dealing in dollars.
Having an international currency may confer power and prestige, but
the benefits therefrom are somewhat nebulous. Nevertheless, historians
and political scientists have sometimes regarded key currency status and
international creditor status, along with such noneconomic factors as
colonies and military power, as among the trappings of a great power.
Some view seigniorage as perhaps the most important advantage of
having other countries hold one's currency. Seigniorage derives from the
fact that the United States effectively gets a zero-interest loan when
dollar bills are held abroad. Just as a travelers' check issuer reaps
profits whenever people hold its travelers' checks, which they are
willing to do without receiving interest, so the United States profits
whenever people in other countries hold dollars that do not pay them
interest. International seigniorage is possible wherever hyperinflation
or social disorder undermine the public's faith in the local currency,
leading them to prefer to hold a sound foreign currency instead. And
today the dollar is the preferred alternative. (Illegal activities are
another source of demand for cash, of course.)
How much does the United States gain from seigniorage? One way to
compute cumulative seigniorage is to estimate the stock of dollars held
abroad and calculate the interest that would otherwise have to be paid
on this ``loan'' to the United States. Foreign holdings of U.S. currency
are conservatively estimated at 60 percent of the total in circulation.
With total currency outstanding in mid-1998 at $441 billion, foreign
holdings are about $265 billion. Multiplying this figure by the interest
rate on Treasury bills yields an estimate for seigniorage of about $13
billion a year.
A final advantage is the ability to borrow in international capital
markets in one's own currency. Some have argued that the United States'
financing of its current account deficit through foreign borrowing has
been facilitated by the ability to issue dollar-denominated liabilities,
and the concern has been expressed that this ability may be hampered by
a loss of reserve currency status. This concern is probably overdone,
however. First, many industrial countries whose currency is not a key
currency are able to borrow in domestic currency. Second, countries with
larger current account deficits than the United States (as a share of
their GDP) have regularly and persistently financed such imbalances with
borrowing in foreign currency rather than their own. Countries become
unable to borrow to finance current account imbal-

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ances when such imbalances become unsustainable. The fact that borrowing
may occur in domestic or foreign currency has little to do with such
sustainability.
Disadvantages of having a key currency. Having an international
currency confers at least two disadvantages on a country. These
drawbacks explain why Germany, Japan, and Switzerland have in earlier
decades been reluctant to have their currencies held and used widely
outside their borders.
The threat of large fluctuations in demand for the currency is one
disadvantage. It might be that the more people around the world hold an
international currency, the more demand for that currency will vary.
Such instability of demand, however, is more likely to follow from the
increase in capital mobility than from key currency status per se. In
any case, central banks are particularly concerned that
internationalization of their currencies will make it more difficult to
control their money stocks. This problem need not arise if they do not
intervene in the foreign exchange market. But the central bank may view
letting fluctuations in demand for the currency be reflected in the
exchange rate as just as undesirable as letting them be reflected in the
money supply.
The second disadvantage is an increase in average demand for the
currency. This is the other side of seigniorage. In the 1960s and 1970s
the Japanese and German governments were particularly worried that, if
domestic assets were made available to foreign residents, an inflow of
capital might cause the currency to appreciate and render the country's
exporters uncompetitive on world markets. Some Europeans today express
the same concern about the euro.

What Factors Determine International Currency Status?

Will the dollar maintain its global role in the foreseeable future?
The answer depends on four major conditions that determine whether a
currency is used internationally.
Patterns of output and trade. The currency of a country that has a
large share in world output, trade, and finance has a natural advantage.
The U.S. economy is still larger than the euro-11 economies combined. If
the United Kingdom and the other remaining EU members (Denmark, Greece,
and Sweden) join EMU in the future, however, the two currency areas will
then be very close in size.
History. There is a strong inertial bias in favor of using whatever
currency has been the vehicle currency in the past. Exporters,
importers, borrowers, lenders, and currency traders are more likely to
use a given currency in their transactions if everyone else is doing so.
For this reason, the world's choice of international currency is
characterized by multiple stable equilibria; that is, any of several
currencies could fill that role under certain conditions. The pound
remained an important international currency even after the United
Kingdom lost its position

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as an economic superpower early in this century. In the present context
the inertial bias favors the continued central role of the dollar.
The country's financial markets. Capital and money markets must be
not only open and free of controls, but also deep, well developed, and
liquid. The large financial marketplaces of New York and London clearly
benefit the dollar and the pound relative to the mark and the yen. It
remains to be seen whether EMU will turn Frankfurt or Paris into one of
the top few world financial centers.
Confidence in the value of the currency. Even if a key currency were
used only as a unit of account, a necessary qualification would be that
its value not fluctuate erratically. In fact, however, a key currency is
also used as a form in which to hold assets (firms hold working balances
of the currencies in which they invoice, investors hold bonds issued
internationally, and central banks hold currency reserves). For these
purposes, confidence that the value of the currency will be stable, and
particularly that it will not at some point be inflated away, is
critical.
In the 1970s the monetary authorities in Germany, Japan, and
Switzerland established a better track record of low inflation than did
the United States, which helped their currencies to achieve greater
international currency status. Given the good U.S. inflation performance
more recently, this is no longer such a concern.

What Is the Prognosis for the Dollar and the Euro?

In light of these desiderata for a would-be international currency,
is it likely that the euro will rival the dollar as the leading
international currency? The euro automatically inherits the roles of the
ecu, the mark, the French franc, and other currencies of the European
Monetary System. Subsequently, the euro's share will probably gradually
rise, moving in the direction of Europe's share of output.
The odds, however, are against the euro's rapidly supplanting the
dollar as the world's premier currency. It is not that the dollar is
ideally suited for the role of everyone's favorite currency. An
international currency is one that people use because everyone else is
using it. Two of the four determinants of reserve currency status--
highly developed financial markets and historical inertia--support the
dollar over the euro. The third, economic size, is a tie (or will be if
the United Kingdom joins EMU). The fourth determinant is also a tie, as
both Europe and the United States have pursued stable monetary policies
aimed at keeping inflation low.
The widespread use of the U.S. dollar as an international currency--
for holding reserves, pegging minor currencies, invoicing imports and
exports, and denominating bonds and lending--is testimony to the
strength of the U.S. economy and the confidence with which it is viewed
around the world. But the direct economic benefits deriving from this
international role are limited. The welfare of a country is measured by
its ability to produce a large quantity of goods and ser-

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vices in demand, and to provide its citizens with sustained increases in
real income and consumption opportunities. Whether a country's currency
is an international currency or not has little to do with such long-run
well-being, as the experience of many successful economies whose
currencies do not have international roles attests. An economically
strong and healthy United States that is also a leader and champion of
sound economic policies has led, as a by-product, to a strong
international role for the U.S. dollar.

CONCLUSION

Reforms are under way to create a strengthened international
financial architecture for the global marketplace in the next
millennium, one that captures the full benefits of international capital
flows and global markets, minimizes the risk of disruption, and protects
the most vulnerable.
The United States has worked intensively with key emerging markets,
other industrial countries, and the relevant international organizations
to put in place the building blocks of this new architecture. The
reforms recommended by the G-22 and adopted by the G-7 are an important
starting point. The United States and its G-7 partners have also agreed
to do more to build a modern framework for the global markets of the
21st century and to limit the swings of boom and bust that destroy hope
and diminish wealth. For these reasons they have also committed
themselves to initiate new work on a number of other important areas, to
identify additional steps to strengthen the international financial
architecture. All these reforms will ensure that the unprecedented
growth and the increase in welfare and opportunity experienced in the 50
years after the creation of the Bretton Woods system are maintained in
the future.
Meanwhile the United States salutes the formation of the European
Monetary Union. The United States has much to gain from the success of
this momentous project. Now more than ever, America is well served by
having an integrated and prosperous trading partner on the other side of
the Atlantic. Europe should benefit from a single currency that supports
these ends--and if Europe benefits, the United States gains as well.