International Financial Crises: Efforts to Anticipate, Avoid, and Resolve
Sovereign Crises (Chapter Report, 07/07/97, GAO/GGD/NSIAD-97-168).

Pursuant to a congressional request, GAO reviewed initiatives and
proposals to anticipate, avoid, and resolve future sovereign financial
crises that might pose a threat to the international financial system,
focusing on: (1) capital market and other mechanisms that are used to
anticipate, avoid, and resolve sovereign financial crises as well as any
limitations of these mechanisms; (2) initiatives that international
financial institutions and others are developing to improve anticipation
and avoidance mechanisms; and (3) initiatives and proposals to improve
methods of resolving sovereign financial crises.

GAO noted that: (1) the possibility that a future sovereign financial
crisis may threaten the stability of the international financial system
cannot be ruled out, and current mechanisms to anticipate, avoid, and
resolve crisis have limitations; (2) one limitation of mechanisms used
to anticipate sovereign financial crises is that countries do not always
supply the necessary information for market participants to accurately
assess investment risks; (3) G-7 country initiatives may help anticipate
and avoid some crises, but a number of obstacles may hinder the
potential effectiveness of these initiatives; (4) for example, the
International Monetary Fund (IMF) has developed a voluntary standard to
improve countries' public disclosures of economic and financial data;
(5) although IMF intends to enforce adherence to the standard, an IMF
official told GAO that IMF lacks the authority and the resources to
ensure the accuracy of these data and plans only limited monitoring to
check for adherence to the data standards; (6) the G-7 has proposed an
initiative to expand the General Arrangements to Borrow to quickly make
more resources available to help resolve sovereign financial crises that
threaten the international financial system; (7) GAO's analysis
indicated that this initiative could reduce the U.S. share of the burden
of resolving future crises, but its use would involve several trade-offs
for the United States; (8) under this proposed initiative, the U.S.
share would be slightly under the 20 percent of the new arrangements'
funds, down from 25 percent under the General Agreements to Borrow; (9)
however, although the U.S. share of the lines of credit would fall, the
actual amount of funds the United States would contribute to the new
lines of credit would increase; (10) use of the New Arrangements to
Borrow would reduce the U.S. share of sovereign financial crisis
resolution funding compared to the 51-percent share that the United
States contributed to the 1995 multilateral financial assistance to
Mexico; (11) however, the reduced U.S. participation in the new
arrangements could dilute U.S. influence by decreasing its voting power,
which might make it harder for the United States to influence activation
of the lines of credit by IMF; and (12) use of the lines of credit could
help to stem a crisis' spread to other countries and forestall systemic
risk, but such use could also increase investors' or countries' moral h*

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD/NSIAD-97-168
     TITLE:  International Financial Crises: Efforts to Anticipate, 
             Avoid, and Resolve Sovereign Crises
      DATE:  07/07/97
   SUBJECT:  International economic relations
             Foreign governments
             Loan defaults
             Investments abroad
             Globalization
             Foreign financial assistance
             Macroeconomic analysis
             Foreign economic development credit
             Monetary policies
             Developing countries
IDENTIFIER:  Mexico
             Argentina
             Malaysia
             Philippines
             Thailand
             Exchange Stabilization Fund
             
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Cover
================================================================ COVER


Report to the Chairman, Committee on Banking and Financial Services,
House of Representatives

July 1997

INTERNATIONAL FINANCIAL CRISES -
EFFORTS TO ANTICIPATE, AVOID, AND
RESOLVE SOVEREIGN CRISES

GAO/GGD/NSIAD-97-168

International Financial Crises

(233492)


Abbreviations
=============================================================== ABBREV

  BIS - Bank for International Settlements
  ESF - Exchange Stabilization Fund
  GAB - General Arrangements to Borrow
  G-7 - Group of Seven
  G-10 - Group of Ten
  IMF - International Monetary Fund
  NAB - New Arrangements to Borrow
  SDR - Special Drawing Rights

Letter
=============================================================== LETTER


B-276469

July 7, 1997

The Honorable James A.  Leach
Chairman, Committee on Banking
 and Financial Services
House of Representatives

Dear Mr.  Chairman: 

This report responds to your request concerning the advantages and
disadvantages of initiatives and proposals to anticipate, avoid, and
resolve future sovereign financial crises that might pose a threat to
the international financial system.  The report (1) identifies
capital market and other mechanisms that are used to anticipate,
avoid, and resolve sovereign financial crises as well as any
limitations of these mechanisms; (2) assesses initiatives that
international financial institutions and others are developing to
improve anticipation and avoidance mechanisms; and (3) evaluates
initiatives and proposals to improve methods of resolving sovereign
financial crises. 

We are sending copies of this report to the Ranking Minority Member
of your committee, the appropriate congressional committees, the
executive branch agencies, the international financial institution
officials, and other interested parties.  We will also make copies
available to others on request. 

This report was prepared under the direction of Susan Westin,
Assistant Director, Financial Institutions and Markets Issues.  Major
contributors to this report are listed in appendix V.  If you have
any questions, please call me at (202) 512-8678. 

Sincerely yours,

Thomas J.  McCool
Associate Director
Financial Institutions
 and Markets Issues


EXECUTIVE SUMMARY
============================================================ Chapter 0


   PURPOSE
---------------------------------------------------------- Chapter 0:1

Mexico's 1994-95 financial crisis has prompted efforts by the Group
of Seven countries (G-7)\1 to seek ways to improve the capability of
the International Monetary Fund (IMF),\2 other official sector
organizations,\3 and capital market participants to prevent or
respond to sovereign financial crises--situations where countries
have been unable or unwilling to pay their debts and, as a result,
have lost access to global capital markets.  Because of concern about
anticipating, avoiding, and resolving crises of comparable magnitude
to Mexico's recent financial crisis, the Chairman of the House
Committee on Banking and Financial Services asked GAO to review
improvement efforts in these areas by international financial
institutions and the industrialized democracies.\4

In this report, GAO identified factors that may increase or decrease
the probability that a future sovereign financial crisis will
threaten the stability of the international financial system and
identified limitations of current market and governmental mechanisms
for preventing and resolving sovereign financial crises.  GAO also
evaluated initiatives and proposals of the G-7\5 and others to better
(1) anticipate and avoid future sovereign financial crises and (2)
resolve these crises when they threaten the international financial
system.  GAO focused primarily on those proposals that have been
implemented or are in the process of being implemented.  These
proposals include the establishment by IMF of voluntary standards
that countries may use when disclosing economic and financial data to
the public; an expansion of the General Arrangements to Borrow, which
are lines of credit that IMF maintains with the Group of Ten
countries (G-10);\6 and an expedited IMF decisionmaking procedure to
extend financing in exceptional circumstances to member countries. 


--------------------
\1 The G-7 consists of seven major industrialized countries that
consult on general economic and financial matters.  The seven
countries are:  Canada, France, Germany, Italy, Japan, the United
Kingdom, and the United States. 

\2 IMF is an organization of 181 member countries that was
established to promote international monetary cooperation, promote
exchange rate stability, and provide short-term lending to member
countries that experience balance-of-payments difficulties.  IMF is
funded by its members who make contributions on the basis of the size
of their economies.  IMF's Executive Board is the primary
decisionmaking body, which comprises 24 Executive Directors who
represent IMF member countries. 

\3 The official sector includes international financial
organizations, such as IMF, the World Bank, and the Bank for
International Settlements, and sovereign governments, such as the
United States. 

\4 In connection with the Chairman's request, GAO has already issued
a report entitled Mexico's Financial Crisis:  Origins, Awareness,
Assistance, and Initial Efforts to Recover (GAO/GGD-96-56, Feb.  23,
1996). 

\5 These proposals are the products of the 1995 Halifax, Nova Scotia,
G-7 economic summit and are contained in the communique issued at the
summit. 

\6 The G-10 consists of 11 countries, which are the G-7 countries
plus Belgium, the Netherlands, Sweden, and Switzerland. 


   BACKGROUND
---------------------------------------------------------- Chapter 0:2

The international financial system brings borrowers of capital into
contact with lenders in their own country or other countries, thereby
facilitating the global availability of capital.  In the last decade,
as the international financial system has grown, many of the larger
and more economically advanced developing countries, often called
"emerging market" countries, have become increasingly important
participants in the system.  These countries generally have benefited
from this inclusion but, in some cases, sovereign financial crises
have occurred.  These crises have harmed the debtor countries because
they often have been accompanied by recession and loss of access to
world capital markets.  The crises also have harmed some creditors of
such countries because they have not been repaid on schedule or in
full. 

Although the effects of a sovereign financial crisis may be limited
to the debtor country and its creditors, some of these crises, such
as Mexico's 1994-95 crisis, have affected other countries' financial
and economic situations.  This has occurred through a "contagion
effect" when, in response to a crisis in one country, investors
removed their funds from other countries.  It can be difficult to
predict whether and to what extent contagion will occur in a
sovereign financial crisis and how long the contagion will last. 

Some past crises also have posed a "systemic risk" to the
international financial system.  Systemic risk is the risk that a
financial disturbance, which triggers substantial unanticipated
changes in the prices of financial assets, may seriously harm the
financial position of large financial firms, which in turn, could
threaten to disrupt the global payments system\7 and the capacity of
the international financial system to efficiently allocate capital. 
Department of the Treasury officials told GAO that systemic risk
could also arise--even without disruption to the payments system--if
an economic or financial shock were to lead to a sharp curtailment of
capital markets' willingness to extend credit to a large number of
countries despite their having relatively strong economic policies
and performances.  The precise extent to which the international
financial system is vulnerable to systemic risk is subject to debate,
and the degree of systemic risk that a particular sovereign financial
crisis could pose is difficult to determine. 

In addition to these uncertainties, which have complicated decisions
by the official sector over whether to intervene in a sovereign
financial crisis to contain contagion and/or minimize systemic risk,
a concern exists that intervention may create or increase "moral
hazard." Moral hazard occurs when investors or debtor countries alter
their financial decisions on the basis of a belief that the official
sector will supply financial assistance to them in a crisis.  Debtor
countries may pursue risky economic or financial policies with the
expectation that, if those policies lead to a financial crisis,
debtor countries will not have to pay the full costs of their debts
and investors will not lose the full amount invested.  As is true
with systemic risk, it is difficult to measure the degree of moral
hazard present in any given situation and the effect on moral hazard
of providing financial assistance in a particular crisis. 

In large measure, the official sector determines whether to intervene
in a sovereign financial crisis by weighing the trade-offs between
stemming contagion and minimizing systemic risk to the international
financial system and creating or by increasing moral hazard for
investors or debtor countries.  Mexico's 1994-95 crisis highlighted
the effects of this trade-off because the need to contain the crisis'
contagion was cited by the U.S.  government and IMF as one
justification for providing financial assistance, while critics of
the assistance cited the increased moral hazard that they believed
the assistance created. 

To achieve its objectives, GAO interviewed officials from Treasury
and the Federal Reserve Board; IMF; investment and commercial banks
based in the United States; U.S.-based emerging market bond and
equity funds; and experts in the areas of international finance,
economics, and law at universities and private organizations.  GAO
also developed a conceptual framework containing a number of elements
to assess the advantages and disadvantages of improvement initiatives
and proposals.  In particular, GAO used this framework to analyze the
trade-offs among different elements, such as resolving crises
quickly, minimizing moral hazard, and sharing the burden of resolving
crises.  In addition, GAO reviewed U.S.  government, international
organization, and private firm documents, including testimony,
reports, books, and laws. 


--------------------
\7 The global payments system creates the means for transferring
money between suppliers and users of funds, usually by exchanging
debits or credits among financial institutions. 


   RESULTS IN BRIEF
---------------------------------------------------------- Chapter 0:3

The possibility that a future sovereign financial crisis may threaten
the stability of the international financial system cannot be ruled
out, and current mechanisms to anticipate, avoid, and resolve crises
have limitations.  Although some factors may have lessened the
likelihood of such a systemic crisis, such as a recent decrease in
potentially volatile portfolio investments in emerging market
countries, other factors may have raised the likelihood of such a
crisis, including continuing large funds flows into these countries,
which may amplify the magnitude of individual crises.  One limitation
of mechanisms used to anticipate sovereign financial crises is that
countries do not always supply the necessary information for market
participants to accurately assess investment risks.  Resolving crises
can be impeded by, among other factors, investors' actions that may
deepen the crisis if they quickly remove their funds from a country
in crisis, and by IMF and creditor countries' governments having
difficulty deciding whether to intervene to help resolve the crisis. 

G-7 country initiatives may help anticipate and avoid some crises,
but a number of obstacles may hinder the potential effectiveness of
these initiatives.  For example, IMF has developed a voluntary
standard to improve countries' public disclosures of economic and
financial data.  Although IMF intends to enforce adherence to the
standard, an IMF official told GAO that IMF lacks the authority and
the resources to ensure the accuracy of these data and plans only
limited monitoring to check for adherence to the data standards. 
Instead, IMF has stated its intention to rely on financial markets to
monitor and enforce compliance with the standards by removing funds
from countries that financial market participants believe have
suspect data. 

The G-7 has proposed an initiative to expand the General Arrangements
to Borrow\8 to quickly make more resources available to help resolve
sovereign financial crises that threaten the international financial
system.  The expanded lines of credit, which are to be called the New
Arrangements to Borrow, would more than double the number of
participating countries and increase the total funds potentially
available from about $23.8 billion to about $47.6 billion.  GAO's
analysis indicated that this initiative could reduce the U.S.  share
of the burden of resolving future crises, but its use would involve
several trade-offs for the United States. 

Under this proposed initiative, the U.S.  share would be slightly
less than 20 percent of the new arrangements' funds, down from 25
percent under the General Arrangements to Borrow.  However, although
the U.S.  share of the lines of credit would fall, the actual amount
of funds the United States would contribute to the new lines of
credit would increase.  This increased U.S.  commitment would require
congressional authorization and an appropriation of $3.4 billion. 
However, a senior Treasury official told us that the additional
commitment would not affect the size of the U.S.  budget deficit
because the budget treats the transfer of dollars to IMF as being
offset by the U.S.  receipt of a monetary asset (i.e., a liquid,
interest-bearing claim on IMF that is backed by IMF's financial
position, including its holdings of gold). 

Use of the New Arrangements to Borrow would reduce the U.S.  share of
sovereign financial crisis resolution funding compared to the
51-percent share that the United States contributed to the 1995
multilateral financial assistance to Mexico.  However, the reduced
U.S.  participation in the new arrangements could dilute U.S. 
influence by decreasing its voting power, which might make it harder
for the United States to influence activation of the lines of credit
by IMF.  Similarly, the increase in participants could make it more
difficult to obtain a consensus to use the lines of credit to stem
contagion.  Use of the lines of credit could help to stem a crisis'
spread to other countries and forestall systemic risk, but such use
could also increase investors' or countries' moral hazard. 


--------------------
\8 The General Arrangements to Borrow are contingent lines of credit
that IMF maintains with the 11 G-10 countries and, under a separate
arrangement, Saudi Arabia. 


   GAO ANALYSIS
---------------------------------------------------------- Chapter 0:4


      FUTURE SYSTEMIC CRISES ARE
      POSSIBLE AND EXISTING
      MECHANISMS TO ANTICIPATE,
      AVOID, AND RESOLVE CRISES
      HAVE LIMITATIONS
-------------------------------------------------------- Chapter 0:4.1

Some factors may have lessened the likelihood that a future sovereign
financial crisis will threaten the stability of the international
financial system, such as a recent decrease in potentially volatile
portfolio investments in emerging market countries and a greater
diversity in the sources of investments.  However, Treasury officials
emphasized that other factors may have increased the probability of
such a crisis, including continuing large funds flows into these
countries that may amplify the magnitude of individual crises,
various trends that may contribute to the volatility of these funds,
and the growing ability of countries to run large current account\9
deficits because private markets will finance the deficits.  Total
net private capital inflows to emerging market countries increased by
more than threefold between 1990 and 1996, from about $60.1 billion
to $193.6 billion.  Thus, the possibility that a future sovereign
financial crisis may threaten the stability of the international
financial system cannot be ruled out.  Treasury officials also said
that many of the factors that increase the likelihood of a systemic
crisis may also produce crises that would require more substantial
official sector resources for their containment. 

Current market and governmental mechanisms to anticipate, avoid, and
resolve sovereign financial crises have limitations.  As GAO learned
in its review of Mexico's 1994-95 financial crisis, sovereign
financial crises have been complex economic, financial, and political
events that were difficult to predict.  Capital market participants
discipline countries that pursue what the participants perceive to be
inappropriate economic or financial policies by lending to those
countries with unsound or inappropriate policies only at higher
interest rates.  The increase in the cost of borrowing, along with
the possibility that investors may stop lending funds altogether, can
provide the incentive for a country's authorities to correct their
policies, which could help avoid a sovereign financial crisis.  Yet,
capital market participants GAO interviewed said that sometimes
countries do not supply, and investors have trouble obtaining from
other sources, the necessary information for market participants to
accurately assess investment risks.  Furthermore, resolving crises
can be hindered by, among other factors, investors' deepening the
crisis by quickly removing their funds from a country in crisis. 
Also, GAO's analysis indicated that IMF and creditor countries'
governments may have difficulty deciding whether to intervene to help
resolve a crisis because at the same time they are debating whether
the crisis warrants intervention, they are also considering the
extent to which intervention could exacerbate moral hazard. 
Therefore, once creditor countries' governments and IMF decide to
intervene, they may not have enough time to provide debtor countries
with sufficient financial assistance to arrest a crisis. 


--------------------
\9 A country's current account measures its transactions with other
countries' transactions in goods, services, investment income, and
other transfers. 


      INITIATIVES MAY HELP
      STRENGTHEN CRISIS
      ANTICIPATION AND AVOIDANCE,
      BUT OBSTACLES MAY IMPEDE
      THEIR EFFECTIVENESS
-------------------------------------------------------- Chapter 0:4.2

GAO's analysis indicated that the G-7 country initiatives to aid in
crisis anticipation and avoidance have the potential to help
anticipate some crises, but obstacles may hinder the initiatives'
full effectiveness.  For example, to help improve the economic and
financial data needed by market participants, IMF has developed a
voluntary standard that countries may use when disclosing such data
to the public.  If countries provide these data in an accurate and
timely way, then the standard should help to improve country data to
financial markets, according to some market participants GAO
interviewed.  As of May 21, 1997, 42 countries had subscribed to the
IMF standard, including a number of developing countries, such as
Argentina, Malaysia, Mexico, the Philippines, and Thailand.  IMF
began allowing countries to subscribe to the standard in April 1996. 

To enforce adherence to the standard by subscribing countries, IMF
has stated its intention to remove from the list of subscribing
countries any nation that does not comply with the standard's
specifications, although at the time of GAO's review, no countries
had been removed from the list.  IMF intends to rely on capital
market participants to monitor and enforce countries' adherence to
the standards because IMF said it lacks the authority and resources
to verify the country data.  Some market participants told GAO (1)
that market participants, for the most part, do not intend to monitor
countries' compliance with IMF's data standards and (2) that they
generally do not expect to keep IMF informed of any compliance
concerns they may have.  Furthermore, financial markets' ability to
discipline countries' policies to avoid sovereign financial crises
has varied, as Mexico's 1994-95 crisis made evident.  The absence of
any ready means to monitor and enforce compliance with IMF's data
dissemination standard may limit how well the standard actually
improves country data.  Furthermore, IMF has no system in place to
regularly track market participants' concerns over compliance. 


      IMF INITIATIVES FOR
      RESOLVING CRISES WOULD
      INVOLVE U.S.  TRADE-OFFS
      RELATIVE TO STEMMING
      CONTAGION, BURDEN SHARING,
      AND MINIMIZING MORAL HAZARD
-------------------------------------------------------- Chapter 0:4.3

Two G-7 initiatives would seek to make more resources available to
IMF and to make these resources available more quickly in a sovereign
financial crisis.  GAO's analysis indicates that these initiatives
would involve some trade-offs for the United States.  Under one
initiative, IMF plans to more than double the number of participants
in the General Arrangements to Borrow lines of credit and double the
resources potentially available under the lines of credit.  Under the
New Arrangements to Borrow, the number of members would be increased
from 11 to 25 countries, and the amount of credit available would
grow from about $23.8 billion to about $47.6 billion.\10 A
congressional appropriation of $3.4 billion would be required to fund
the U.S.  portion of the expansion.  The new lines of credit could be
activated when participants, representing 80 percent of the credit
lines' resources, determine that there is a threat to the
international financial system and that IMF lacks the resources to
provide the needed funds. 

GAO notes that, although the New Arrangements to Borrow would
increase the official resources available to help resolve sovereign
financial crises that may have a contagion effect on other countries'
finances or that may pose some risk to the international financial
system, U.S.  influence in decisions to use the new lines of credit
could be reduced, and the existence or use of the arrangement might
worsen moral hazard. 

Because the U.S.  proportional share of the new lines of credit is to
fall from 25 percent under the general arrangement to about 20
percent, U.S.  voting share would decrease, and hence the United
States' influence might be diminished.  Similarly, the larger number
of countries in the New Arrangements to Borrow could complicate
activation, since more countries will likely have to consent to
activate the new lines of credit. 

However, to the extent that the new lines of credit can be activated
by its participants, the United States might be less likely to be
called on unilaterally to provide financial assistance to countries
in financial trouble.  On the other hand, to the extent that the
expanded arrangements are difficult to activate, the United States
may continue to face the difficult decision of whether to act
unilaterally to assist financially troubled countries. 

Furthermore, while activation of the New Arrangements to Borrow could
stem contagion in a crisis, use of these funds could also exacerbate
moral hazard for investors and debtor countries.  However, the United
States would more easily be able to block activation of the new lines
of credit because their activation would require the votes of
countries holding 80 percent of the new arrangements' resources,
which is up from 60 percent under the General Arrangements to Borrow. 
Therefore, the United States, with its almost 20-percent share, would
be able to prevent use of the lines of credit if it had the support
of any one other large New Arrangements to Borrow participating
country or two small participants.  Treasury officials told GAO that
moral hazard cannot be entirely eliminated but that it can be held to
a minimum if official intervention in sovereign financial crises is
rare and limited to exceptional circumstances.  They also said that
some moral hazard already exists due to the presence of IMF and other
official sector organizations that provide financing to countries in
crisis, but that policy conditionality and phasing of disbursements
helps to limit that moral hazard. 

IMF has implemented a second G-7 initiative that allows IMF's
Executive Directors to expedite the Board's decisionmaking procedure
to extend financing to member countries.  Called the emergency
financing mechanism, use of the new procedure is limited to
extraordinary situations that threaten member countries' financial
stability, that have significant risks of contagion, and that require
accelerated IMF-debtor country negotiations.  The decisionmaking
mechanism, among other purposes, is designed to help provide a speedy
official response to stem contagion effects on financial markets in
other countries and, possibly, to forestall or mitigate international
systemic risk. 

In some sovereign financial crisis situations, a faster IMF
decisionmaking process could, by reducing systemic risk, reduce
pressure on the United States to act unilaterally.  However, the
emergency mechanism may not facilitate speedier funding decisions
because it may not lessen disagreement among IMF Executive Directors
about the seriousness (i.e., the extent of potential contagion or
systemic risk) of any particular crisis they confront. 


--------------------
\10 Dollar values are converted from Special Drawing Rights (SDR) at
the rate of 1.40 SDRs per dollar.  (GAO took the May 30, 1997, rate
of 1.3918 SDR/dollar and rounded it up to 1.4 SDR/dollar.) SDR is a
unit of account that IMF uses to denominate all of its transactions. 
Its value comprises a weighted average of the value of five
currencies, of which the U.S.  dollar has the largest share. 


   RECOMMENDATION
---------------------------------------------------------- Chapter 0:5

GAO is not making any recommendations in this report. 


   AGENCY COMMENTS
---------------------------------------------------------- Chapter 0:6

GAO obtained written comments on a draft of this report from Treasury
and the Federal Reserve.  These comments are described in chapter 1. 
Both Treasury and the Federal Reserve generally said that the report
was a constructive and reasonably comprehensive contribution to the
analysis of the issues.  Both Treasury and the Federal Reserve
suggested clarifications and technical changes, which GAO
incorporated throughout this report, as appropriate. 


INTRODUCTION
============================================================ Chapter 1

Mexico's financial crisis of 1994-95 prompted Group of Seven (G-7)
country\1 initiatives\2 to improve existing mechanisms to anticipate,
avoid, and resolve sovereign financial crises as well as proposals to
create new mechanisms.  This report responds to the request of the
Chairman of the House Committee on Banking and Financial Services
that we review and evaluate these improvement initiatives and
proposals.  The Chairman also requested that we review various
aspects of Mexico's financial crisis.  We provided the results of our
review of the Mexico crisis in an earlier report\3 that focused on
the origins of the financial crisis; the awareness of U.S. 
government and International Monetary Fund (IMF)\4 officials of
Mexico's situation during 1994; and the financial assistance package
provided by the United States, IMF, and others to help resolve the
crisis. 


--------------------
\1 The G-7 consists of seven major industrialized countries that
consult on general economic and financial matters.  The seven
countries are:  Canada, France, Germany, Italy, Japan, the United
Kingdom, and the United States. 

\2 The initiatives were the product of the 1995 G-7 economic summit
in Halifax, Nova Scotia, and were discussed in the communique issued
at that meeting. 

\3 Mexico's Financial Crisis:  Origins, Awareness, Assistance, and
Initial Efforts to Recover (GAO/GGD-96-56, Feb.  23, 1996). 

\4 IMF is an organization of 181 member countries that was
established to promote international monetary cooperation, promote
exchange rate stability, and provide short-term lending to member
countries that experience balance-of-payments difficulties.  A
country with a balance-of-payments deficit experiences an excess
demand for foreign currencies, i.e., an excess supply of its own
currency.  In such cases, countries do not take in enough foreign
currency to pay for what they buy from other countries.  Absent
central bank intervention, the country's exchange rate will
depreciate in value. 


   BACKGROUND
---------------------------------------------------------- Chapter 1:1


      THE INTERNATIONAL FINANCIAL
      SYSTEM CONNECTS LENDERS TO
      BORROWERS IN DIFFERENT
      COUNTRIES
-------------------------------------------------------- Chapter 1:1.1

The international financial system brings international lenders of
funds, in their own country or other countries, into contact with
borrowers--thereby permitting an increased flow of scarce funds
toward their most productive uses.  This system, which is dominated
by central banks, government agencies, the largest commercial and
investment banks, security and foreign exchange dealers, and major
brokerage houses, has grown enormously in the 1990s.  Global foreign
exchange trading--fueled by floating foreign exchange rates\5 and the
expansion of world commerce--now exceeds $1 trillion a day.\6

Many of the larger and more economically advanced developing
countries, often called "emerging market" countries,\7 which in the
past did not participate much in the international financial system,
have become important players in the last decade.  Private capital
flows to developing countries increased by more than threefold
between 1990 and 1996, rising from $60.1 billion to about $193.6
billion, according to IMF.  These countries' entry into the global
financial system has been fueled by technological advances that make
investment across national borders easier, financial deregulation and
economic liberalization, and other factors. 


--------------------
\5 Under a floating exchange rate system, the value of a country's
currency in relation to other currencies changes in response to
market supply and demand for the currencies, rather than at a rate
set by that government. 

\6 International Capital Movements and Foreign Exchange Markets,
Group of Ten (Rome, Italy:  Apr.  1993). 

\7 "Emerging markets" or "developing countries" are usually those
countries whose production sector is dominated by agriculture and
mineral resources and countries that are in the process of building
up industrial capacity.  In this report, we use these two terms
interchangeably. 


      SOVEREIGN FINANCIAL CRISES: 
      CAUSES AND EFFECTS
-------------------------------------------------------- Chapter 1:1.2

Developing countries have benefited from their increased access to
world capital markets.  Nonetheless, financial crises in developing
countries still have occurred.  For purposes of this report, the term
"sovereign financial crisis" refers to a state of affairs in a
country characterized by the following: 

  -- the inability or unwillingness of a country to honor its debt
     obligations and

  -- the loss of confidence in that country's capital and other
     markets, which can happen when the country does not honor its
     debts, expressed by the flight of capital from the country and a
     general unwillingness of new investors to invest in the country. 

According to a financial risk rating firm, 70 countries defaulted on
various kinds of debt between 1975 and 1995; in 1995 alone, 36
countries were in default on some of their debts.  All of these
countries were either developing countries or countries that were
part of the Soviet Union or Soviet-dominated Eastern Europe. 

Sovereign financial crises have had a variety of causes and effects. 
As we learned in our review of Mexico's 1994-95 financial crisis,
many such crises have had complex economic, financial, and political
origins, including events inside of the country, outside of the
country, or both.  Internal events that have contributed to sovereign
financial crises have included the adoption of macroeconomic policies
that are inconsistent with exchange rates, and political shocks, such
as assassinations in Mexico in 1994.  External contributing events
have included loss of the confidence of investors from other
countries; rising interest rates in other countries, such as occurred
in the early 1980s; and sudden increases in petroleum prices, which
happened in the 1970s. 

Sovereign financial crises can harm both the indebted country and its
creditors.  If a country in financial crisis has debt-servicing
problems, creditors who hold the country's debt must wait longer than
they anticipated to get paid and may not get paid the full value of
their investments.  A country undergoing a financial crisis may
experience severe inflation, recession, a rise in unemployment, and
other harm.  Also, a sovereign financial crisis can lead to
substantial harm to a country beyond the short term because the
crisis can impair the country's access to international capital
markets for years after the immediate crisis is resolved. 


      THE CONTAGION EFFECT:  THE
      SPREAD OF ONE COUNTRY'S
      FINANCIAL CRISIS TO OTHER
      COUNTRIES
-------------------------------------------------------- Chapter 1:1.3

The effects of a sovereign financial crisis largely may be limited to
the country in which it arose and to the country's creditors.  For
example, Venezuela's financial crisis in 1995 did not have financial
effects on other countries' finances, according to international
financial experts.\8 However, some crises have affected other
countries' financial situations through a "contagion effect."
Contagion has occurred when investors, who could be domestic or
foreign, have removed their funds from other countries, or reduced
their new lending to them, in response to a sovereign financial
crisis in another country.  Contagion from Mexico's 1994-95 financial
crisis had a negative impact on the finances of Brazil, Argentina,
and other countries.  It can be difficult to predict whether, and to
what extent, contagion will occur in a sovereign financial crisis and
how prolonged the contagion will be.  Delay by public authorities in
acting to contain a sovereign financial crisis' contagion may or may
not have long-term consequences on the countries that are affected by
the contagion. 


--------------------
\8 This may have been in part because, according to one financial
risk rating firm, Venezuela, in 1995, defaulted only on local
currency-denominated debt held by Venezuelans, while it continued to
service its foreign-currency-denominated debts. 


      SYSTEMIC RISK TO THE
      INTERNATIONAL FINANCIAL
      SYSTEM
-------------------------------------------------------- Chapter 1:1.4

Some sovereign financial crises may have threatened the stability of
the international financial system.  This "systemic risk" is the risk
that a disturbance in financial markets, which triggers substantial
unanticipated changes in the prices of financial assets, might
seriously harm the financial position of financial firms, which could
in turn threaten to disrupt the payments system\9

and the capacity of the international financial system to allocate
capital. 

For example, collapsing asset prices might lead to the financial
failure of one or more of the large securities firms that hold the
assets.  Because of the interrelationships among large financial
companies, this initial financial failure might lead to further
failures by other securities firms and commercial banks.  A series of
such failures by banks and other financial firms might disrupt the
flow of payments in the settlement of financial transactions
throughout the world.  Such a breakdown in international capital
markets might disrupt the process of saving and investing, undermine
the long-term confidence of private investors, and disrupt the normal
course of international economic transactions.  Department of the
Treasury officials told us that systemic risk can also arise--even if
there were no disruptions of the payments system--if a financial,
economic, or political shock were to lead to a sharp curtailment of
the willingness to extend credit to a large number of countries
despite their having relatively strong economic policies and
performance. 

The precise extent to which the international financial system is
vulnerable to this systemic risk is subject to debate.  Furthermore,
it can be difficult to predict the degree of systemic risk to the
international financial system that would result from a particular
sovereign financial crisis. 


--------------------
\9 Broadly, the payments system is the financial system that creates
the means for transferring money between suppliers and users of
funds, usually by exchanging debits or credits among financial
institutions. 


      MORAL HAZARD:  ALTERED
      INCENTIVES FOR INVESTORS AND
      BORROWING COUNTRIES
-------------------------------------------------------- Chapter 1:1.5

Investors may alter their investment decisions and countries may
change their economic policies if they expect assistance from
international financial institutions or other governments.  This is
often called "moral hazard." Investors may believe that the risks of
investing in a particular country or group of countries are lowered
if they expect that, at times of sovereign financial crisis, official
assistance will be forthcoming and sufficient to guarantee their
expected investment return.  Debtor countries may be more willing to
have unsustainable financial and economic policies if they expect
they can get financial assistance without severe consequences at some
later date. 


      DECISIONS TO ACT MAY BALANCE
      CONCERNS ABOUT SYSTEMIC RISK
      AND MORAL HAZARD
-------------------------------------------------------- Chapter 1:1.6

Countries with financial problems may seek financial assistance from
IMF or other countries.  Those asked to provide financial assistance
may consider the trade-off between (1) systemic risk, i.e., the
extent to which the financial problems of an individual country are a
threat to the international financial system and (2) moral hazard,
i.e., the impact of any assistance provided on the future behavior of
countries and investors.  To the extent that systemic risk is judged
to be small, IMF or other official sector organizations may decide
that the country and its creditors should be left to work out a
solution on their own.  To the extent that the official sector judges
that the threat of systemic risk is great, they may provide
assistance to safeguard the international financial system.  Those
who would provide financial assistance may also consider the extent
to which a decision to provide assistance to a country experiencing
financial difficulties could influence the future behavior of both
debtor countries and investors.  These judgments are difficult ones
given that the extent to which both systemic risk and moral hazard
are present in any particular set of financial circumstances is
uncertain. 


   MEXICO'S 1994-95 CRISIS
   THREATENED THE COLLAPSE OF ITS
   PUBLIC FINANCES AND BANKING
   SYSTEM AND CAUSED CONTAGION
---------------------------------------------------------- Chapter 1:2

Mexico's financial crisis of 1994-95, which was a result of the
interplay of complex financial, economic, and political factors,
threatened the collapse of Mexico's public finances and banking
system.  The 1994-95 crisis spread to other emerging market
countries, thereby negatively affecting the financial stability of
those countries.  At the beginning of 1994, which was a presidential
election year in Mexico, Mexico was experiencing a boom in foreign
investment--much of it equity and debt portfolio investments\10 that
could be withdrawn quickly.  However, investor confidence in Mexican
debt and equity securities was shaken throughout 1994 by political
events, including the March 1994 assassination of the leading Mexican
presidential candidate.  Also, U.S.  interest rates began to rise,
which made Mexican debt securities relatively less attractive to
investors. 

To continue to attract foreign investment, the Mexican government
could have raised interest rates, reduced government expenditures, or
devalued the peso.  However, raising interest rates and reducing
government spending were politically unattractive approaches in 1994,
and devaluing the peso would have altered agreements among
government, labor, and business and would have hurt foreign
investors.  Rather than adopt any of these options, the Mexican
government, in the spring of 1994, increased issuance of short-term,
dollar-linked bonds, called tesobonos.  The short-term maturity of
tesobonos enabled holders of the bonds to choose not to roll them
over\11 if they perceived either an increased risk of a Mexican
government debt-servicing problem or higher returns elsewhere.  Many
tesobono purchasers were portfolio investors who were sensitive to
changes in interest rates and risks. 

Following the August 1994 election, foreign investment flows did not
recover to the extent expected by the Mexican government.  Foreign
exchange reserves held by Mexico's central bank, which amounted to
about $29 billion in February 1994, fell to $12.5 billion in the
beginning of December 1994, with Mexican tesobono obligations of
nearly $30 billion maturing in 1995.  On December 20, 1994, Mexico
devalued the peso.  The discrepancy between (1) the Mexican
government's long-standing pledge not to devalue the peso and (2) the
sudden devaluation, absent an announcement of appropriate
accompanying economic policy measures, contributed to a sharp, sudden
loss of investor confidence in the newly elected government and a
growing fear that a Mexican government default was likely in 1995. 
Investor confidence collapsed as investors sold Mexican equity and
debt securities, and foreign currency reserves at the Bank of Mexico
were insufficient to meet the demand of investors seeking to convert
pesos to U.S.  dollars.  The peso devaluation precipitated a crisis
that continued into 1995. 

Early in Mexico's crisis, financial markets in a number of emerging
market economies were affected by Mexico's problems as investors
began to limit capital flows to these countries.  According to a
later analysis by IMF, portfolio investment flows to emerging markets
declined dramatically in the first quarter of 1995.  Also, risk
premiums on developing countries' bonds increased, equity prices in
emerging markets fell sharply, and currency pressures were felt, at
least temporarily, in a geographically dispersed group of economies,
which ranged from Argentina and Brazil to Hong Kong and South Africa. 
In our report on Mexico's crisis, we noted that stock markets in
Argentina and Brazil were especially hard hit by contagion, and that
no new international equities were issued in six major emerging
market countries in the first quarter of 1995. 


--------------------
\10 Portfolio investments are assets held in the form of marketable
equity and debt securities.  Portfolio investment, in contrast to
direct investment, tends to be more liquid in nature and is more
likely to be short term.  However, this is not to suggest that
selling pressures on a currency are more likely to arise or to be
more severe in the presence of substantial foreign portfolio
investment.  Historically, market-forced devaluations have occurred
even when portfolio investment has been almost nonexistent. 

\11 We use the term "roll over" here to mean repurchase of tesobonos
when the tesobonos held by the investor matured. 


   MEXICO'S 1994-95 FINANCIAL
   CRISIS LED TO U.S.  AND
   MULTILATERAL FINANCIAL
   ASSISTANCE
---------------------------------------------------------- Chapter 1:3

Citing risk of contagion and the threat to U.S.  interests of a
prolonged Mexican recession, among other concerns, U.S.  and IMF
officials orchestrated a large financial assistance package to
Mexico.  The assistance package consisted of up to $48.8 billion from
the United States, Canada, IMF, and the Bank for International
Settlements (BIS).\12 The primary goal of the assistance package was
to enable Mexico to overcome its short-term liquidity crisis, and
thereby to prevent Mexico's financial collapse, and to prevent the
further spread of the crisis to other emerging market countries. 
U.S.  officials also were concerned that Mexico's crisis could
escalate into a prolonged and severe economic downturn that would
damage U.S.  interests, including trade, employment, and immigration. 
U.S.  officials--who said that they viewed Mexico as a paradigm for
countries striving toward a free market economy--also believed that
if Mexico's difficulties spread to other emerging market countries,
the global trend toward market-oriented reform and democratization
could have halted or even reversed. 

The assistance provided by the United States and IMF was large in
amount and quickly provided.  On January 31, 1995, which was less
than 6 weeks after Mexico's financial crisis began, President Clinton
announced that Treasury's Exchange Stabilization Fund (ESF)\13 and
the Federal Reserve's swap network would be used to provide up to $20
billion to Mexico.\14 Both sources of funds could be activated
without additional legislation\15 by Congress.\16 The next day,
February 1, 1995, IMF approved an 18-month standby arrangement for
Mexico of up to $17.8 billion.  IMF's quick approval of this
arrangement was unusual, considering that arrangements for IMF
financial assistance to indebted countries typically required months
of detailed negotiations among IMF, the country, and the country's
creditors.  Although the U.S.  and IMF portion of the assistance
package totaled almost $38 billion, Mexico eventually used about
$13.5 billion of the U.S.  funds and about $13 billion of the IMF
funds.  Mexico has repaid all of the funds it borrowed from the
United States. 

IMF's contribution to the assistance package was the largest
financing package ever approved for an IMF member country, both in
terms of the amount and the overall percentage of a member's
subscription quota.\17 About 688 percent of Mexico's subscription
quota was provided over 18 months (under ordinary circumstances, the
usual cumulative limit is 300 percent).  The United States'
contribution of $13.5 billion represented about 51 percent of the
total assistance package used. 

The financial assistance helped to arrest the crisis and restore
financial market confidence in Mexico.  Although Mexico's economy
went into a recession as a result of the crisis, the contagion to
other countries ceased and most of the affected countries recovered
from the contagion within a few months.  In the spring of 1995,
Mexico regained access to international capital markets. 


--------------------
\12 BIS is an organization of central banks that is based in Basle,
Switzerland.  It is the principal forum for consultation,
cooperation, and information exchange among central bankers. 

\13 ESF is a currency reserve fund under the control of the Secretary
of the Treasury that is employed to stabilize the dollar and foreign
exchange markets.  ESF holds foreign currencies, such as the Japanese
yen and German mark, as well as U.S.  dollars and Special Drawing
Rights (SDR).  SDRs are units of account issued by IMF to supplement
gold and currency reserves.  The value of special drawing rights
fluctuates relative to five major currencies.  In the past, ESF has
been used to buy and sell foreign currencies, extend short-term swaps
to foreign countries, and guarantee obligations of foreign
governments.  ESF use must be consistent with U.S.  obligations in
IMF regarding orderly exchange arrangements and a stable system of
exchange rates. 

\14 An initial proposal by the President on January 12, 1995, for up
to $40 billion in loan guarantees to Mexico from the United States
failed to gain sufficient congressional support.  These funds would
have come from a congressional appropriation specifically for that
purpose, in contrast to the Treasury and Federal Reserve funds that
were used to assist Mexico. 

\15 Subsequently, in the spring of 1995, the Mexican Debt Disclosure
Act was passed, requiring the President to submit a report before any
funds under this program could be extended. 

\16 Some Members of Congress questioned the administration's
authority to use ESF to assist Mexico without congressional approval. 
In our report on the Mexican crisis, we found no basis to disagree
with the administration's position that the Secretary of the
Treasury, with the President's approval, had the requisite authority
to use ESF in this manner. 

\17 As a condition of membership, each IMF member is required to
contribute to the general resources of IMF.  These contributions are
referred to as that member's subscription quota and determine the
voting power of each member.  Members usually pay up to 25 percent of
their subscription quota in SDRs or a convertible currency and the
other 75 percent or more in the member's domestic currency.  The
United States' quota, about $36 billion, is the largest in IMF and
constitutes about 18 percent of the total quotas. 


   FINANCIAL ASSISTANCE TO MEXICO
   WAS CONTROVERSIAL
---------------------------------------------------------- Chapter 1:4

Some observers argued that the United States should not have provided
financial assistance to Mexico, often citing one or more of the
following reasons:  (1) the threat Mexico's crisis posed to other
countries was insufficient to justify the assistance; (2) the
assistance would inappropriately shield investors and countries from
the consequences of their financial decisions and thereby increase
moral hazard; and (3) the threat posed to U.S.  trade, employment,
and immigration interests was insufficient to justify the assistance. 


      EXTENT OF THREAT TO THE
      INTERNATIONAL FINANCIAL
      SYSTEM WAS IN DISPUTE
-------------------------------------------------------- Chapter 1:4.1

Some critics of U.S.  financial assistance to Mexico argued that the
effects of Mexico's crisis on other countries did not justify risking
up to $20 billion of U.S.  funds or the large amount of IMF funds. 
The critics said that the contagion effect was either (1) a temporary
market overcorrection that would have reversed itself before
seriously harming U.S.  investors or other emerging markets or (2) an
appropriate market correction of overinvestment in these markets. 
One study, by an association of commercial banks, investment banks,
and other financial institutions, argued that the Mexican crisis'
contagion was mostly ephemeral because some affected countries were
able to borrow in international capital markets within 6 months after
the crisis.\18 Investment flows to emerging market
countries--including some hardest hit by the contagion--have been
large in the 2 years since Mexico's crisis.  Some analysts also
argued that the diversity of the holders of Mexico's debt in 1994-95,
as well as the diversification of investment and loan portfolios,
meant that the crisis did not pose a systemic threat to the
international financial system because it did not threaten the health
of any large, creditor country financial institutions. 

Proponents of the assistance to Mexico argued that the contagion
effects of the crisis were short lived, at least partly, because of
the stabilizing effect of the multilateral financial assistance to
Mexico (i.e., the assistance stopped the contagion from deepening or
spreading).  Furthermore, Treasury officials told us that they
believed that Mexico's 1994-95 crisis would have threatened the
stability of the international financial system had it endured
because, in their view, other major emerging market countries would
have lost access to world capital markets for an extended time. 


--------------------
\18 Resolving Sovereign Financial Crises, Institute of International
Finance, Inc.  (Sept.  1996). 


      EFFECT ON MORAL HAZARD WAS
      CONTROVERSIAL
-------------------------------------------------------- Chapter 1:4.2

Some opponents of the U.S.  financial assistance to Mexico have
argued that the assistance has created substantial moral hazard for
debtor countries as well as investors in those countries.  The
opponents have said that providing the Mexican government with the
foreign currency it needed to redeem matured tesobonos exacerbated
moral hazard for investors in emerging market countries by protecting
tesobono holders from losses on those bonds.\19 Some observers have
also argued that moral hazard may have contributed to Mexico's
1994-95 financial crisis (i.e., earlier assistance to Mexico had
encouraged Mexican officials to pursue a mix of risky macroeconomic
and financial policies and encouraged investors to purchase large
amounts of tesobonos and inadequately monitor the risks of these and
other portfolio investments in Mexico).\20

According to our analysis, these assertions could be countered with
three arguments.  First, administration officials said that the 1995
U.S.  and IMF assistance was conditioned upon Mexico's adhering to
strict economic, financial, and reporting requirements.  These
conditions may have helped to mitigate any increased moral hazard for
Mexico and other debtor countries.  These officials also noted that
the assistance did not prevent the crisis from causing a severe
recession in Mexico.  Mexico's severe recession could underscore for
Mexico and other countries the negative consequences of risky
financial policies.  Second, some financial analysts have asserted
that moral hazard existed, to some extent, before Mexico's recent
crisis and that it will continue to exist no matter what policymakers
do or say.  The analysts said that both investors and debtor
countries will continue to consider in their borrowing and lending
decisions the availability of financing from IMF as well as financing
from major creditor country governments with an interest in the
financial stability of the debtor country.  Third, investors and
debtor countries may interpret the controversy surrounding the
decision to assist Mexico as evidence that such action is unlikely to
be repeated.  Officials within the administration and some Members of
Congress disagreed about assisting Mexico.  Furthermore, officials
representing the U.S.  government disagreed with officials from other
major IMF member country governments.  In May 1996, the Group of Ten
(G-10)\21 governments stated that investors, including bondholders,
and governments should not expect the Mexican financial assistance to
be repeated. 


--------------------
\19 Holders of tesobonos, along with other investors in Mexico, may
have experienced financial losses on other investments in Mexico as a
result of the crisis, including losses on equity investments in
Mexico's stock market.  Mexico's stock market dropped by two-thirds
(68 percent) in dollar terms between December 19, 1994, and March 9,
1995. 

\20 For example, in 1982 the United States, some BIS central banks,
IMF, and international commercial banks provided financial assistance
when Mexico became unable to make loan payments to U.S.  and other
foreign commercial banks. 

\21 The G-10 is made up of 11 major industrialized countries that
consult on general economic and financial matters.  The 11 countries
are:  Belgium, Canada, France, Germany, Italy, Japan, the
Netherlands, Sweden, Switzerland, the United Kingdom, and the United
States. 


      THE SERIOUSNESS OF THREATS
      TO U.S.  TRADE, IMMIGRATION,
      EMPLOYMENT, AND OTHER
      INTERESTS WAS DEBATED
-------------------------------------------------------- Chapter 1:4.3

Some critics of the U.S.  financial assistance to Mexico have also
argued that the threat the crisis presented to U.S.-specific
interests, such as trade, employment, and immigration, was
insufficient to justify the assistance.  Some critics of the
assistance to Mexico argued that the potential losses in U.S.  jobs
would not have been great and that a large influx of illegal
immigration may not have followed if Mexico had worked out the crisis
without outside assistance.  U.S.  government officials, citing the
growth in the Mexican economy and the economic interdependence of the
United States and Mexico, argued that the United States had an
interest in protecting trade with Mexico--which they said would limit
U.S.  job losses stemming from the crisis--and in preventing a
Mexican economic collapse.  Moreover, the officials said, a Mexican
economic collapse would have led to a surge of illegal immigration
into the United States. 


   OBJECTIVES, SCOPE, AND
   METHODOLOGY
---------------------------------------------------------- Chapter 1:5

The Chairman of the House Committee on Banking and Financial Services
requested that we review and evaluate initiatives and proposals to
improve the means of anticipating and resolving financial crises. 
One of our objectives was to identify (1) factors that may increase
or decrease the probability that a future sovereign financial crisis
will threaten the stability of the international financial system and
(2) any limitations of current market and governmental mechanisms for
preventing and resolving sovereign financial crises.  Our other
objective was to evaluate initiatives and proposals of the G-7 and
others to better (1) anticipate and avoid future sovereign financial
crises and (2) resolve such crises that threaten the international
financial system. 

To achieve these objectives, we interviewed U.S.  government and
international financial institution officials from Treasury, the
Federal Reserve, the Department of Commerce, IMF, and the World Bank. 

We collected and analyzed documents and interviewed international
investors and investment experts from the following: 

  -- commercial and investment banks based in the United States,

  -- U.S.-based emerging market bond and equity mutual funds,

  -- professional organizations representing capital market
     participants,

  -- a U.S.-based law firm that represents countries in financial
     distress, and

  -- international finance and economic experts at universities and
     private research organizations. 

We reviewed documents and interviewed officials to obtain information
about the following: 

  -- the investment flows to and from emerging market countries;

  -- the history of sovereign financial crises;

  -- the workings of the international financial system and threats
     to its stability;

  -- the genesis of sovereign financial crises and their effects on
     the finances and economies of other countries;

  -- the trade-off between systemic risk and altered incentives for
     investors and emerging market countries;

  -- how financial markets assess the risks of investing in emerging
     markets, and how markets try to anticipate and avoid sovereign
     financial crises;

  -- the efforts under way by governments and the international
     financial institutions to improve anticipation and avoidance of
     sovereign financial crises;

  -- the current and proposed mechanisms for resolving sovereign
     financial crises; and

  -- the U.S.  budgetary implications of expanding the General
     Arrangements to Borrow. 

The documents that we collected and analyzed included books,
articles, reports, and testimony.  We attended several conferences
dealing, in part, with sovereign financial crises.  Finally, we used
information that we had previously gathered for our February 1996
report on the 1994-95 Mexican financial crisis. 

To evaluate initiatives and proposals to better resolve future
financial crises, we developed a conceptual framework with 10
elements.  We received written comments on the draft framework from
officials representing the public and private sectors and
incorporated their comments to finalize the framework.  As a part of
our analysis, we sought to determine whether and how each initiative
and proposal could

(1)limit contagion and systemic risk to the international financial
system, including responding to a crisis with sufficient speed and
quantity of resources;

(2)affect moral hazard;

(3)induce appropriate country economic and financial policies;

(4)address the cost-effectiveness associated with development and
implementation;

(5)share burdens among parties in a sovereign financial crisis;

(6)facilitate coordination and communication among parties in a
crisis;

(7)be flexible enough to deal with various types of financial crises;

(8)apply principles consistently to countries in similar financial
distress;

(9)address the legal requirements needed for development and
implementation; and

(10)apportion the administrative burden of development and
implementation. 

We did not use the conceptual framework to endorse or reject any
particular initiative or proposal.  Appendix I provides more detail
on how we developed the framework.  We conducted our work between
March 1996 and March 1997 in accordance with generally accepted
government auditing standards. 


   AGENCY COMMENTS
---------------------------------------------------------- Chapter 1:6

We obtained written comments on a draft of this report from Treasury
and the Federal Reserve.  Comment letters are reproduced in
appendixes III and IV.  Both agencies generally said the report is
constructive and a reasonably comprehensive analysis of these issues. 
In addition, both Treasury and the Federal Reserve provided
suggestions for clarifications and technical changes.  Treasury's
clarifications and technical comments included suggestions from the
U.S.  Executive Director's Office at IMF.  We discussed Treasury's
comments with Treasury officials in a meeting on May 30, 1997.  We
incorporated the suggestions throughout this report, as appropriate. 


MECHANISMS THAT HELP ANTICIPATE,
AVOID, AND RESOLVE SOVEREIGN
FINANCIAL CRISES HAVE LIMITATIONS
============================================================ Chapter 2

The possibility of a future sovereign financial crisis threatening
the stability of the international financial system cannot be ruled
out, and current mechanisms for anticipating, avoiding, and resolving
sovereign financial crises have limitations.  Some factors may have
lessened the likelihood of such a systemic crisis, such as a recent
decrease in potentially volatile portfolio investments in emerging
market countries and a greater diversity in the sources of
investments.  Yet, other factors may have increased the probability
of such a crisis, including continuing large funds flows into these
countries, which may amplify the magnitude of individual sovereign
financial crises and various trends that may contribute to the
volatility of these funds. 

There are a variety of official and private sector mechanisms that
can help anticipate, avoid, and resolve sovereign financial crises. 
Debtor country economic and financial policies that retain investor
confidence can help avoid sovereign financial crises.  Debtor country
provision of information about their economic and financial
situations can help anticipate and avoid sovereign financial crises. 
When investors avoid or sell country-related investments, this can
signal a country that its policies are inappropriate or unsound. 
Economic monitoring and advisory activities by IMF and some major
industrialized creditor countries can help emerging market countries
adjust policies and practices that may lead to future problems. 
Major mechanisms to help resolve sovereign financial crises include
IMF financial assistance, along with its conditions, and conventions
for negotiations between debtor countries, the official sector, and
commercial bank creditors. 

Mexico's 1994-95 financial crisis and other sovereign financial
crises have shown the limitations of mechanisms designed to help
anticipate and avoid sovereign financial crises.  Sovereign financial
crises have been complex financial, economic, and political events
that are difficult to anticipate, despite the various risk
assessments and monitoring efforts of market participants, IMF, and
creditor countries.  When debtor countries or investors expect
official funding to resolve a sovereign financial crisis--a situation
known as moral hazard--they may pursue risky policies and risky
investments.  Also, weak commercial banks and lax bank supervision in
emerging market countries can turn away investors.  IMF and creditor
country government surveillance of emerging market countries may not
sufficiently focus on country financial policies. 

Problems have also impeded official and private sector mechanisms to
contain and efficiently resolve sovereign financial crises when they
do occur.  When a country has debt-servicing problems, investors can
have strong incentives to sell their country-related investments even
though investors might be better off as a group if they continue to
hold their investments.  Resolution may also be delayed by
difficulties in organizing interim funds that indebted countries
sometimes need in a crisis.  Some smaller creditors may seek to be
bought out by other creditors and delay negotiations.  IMF and
creditor country governments may have difficulty deciding whether to
intervene to help resolve a sovereign financial crisis as
decisionmakers debate whether the crisis warrants intervention and
the extent to which intervention could create improper expectations
about how the official sector may act in the future.  Finally,
creditor country governments and IMF can experience difficulties in
providing sufficient financial assistance quickly enough to arrest a
crisis. 


   SOVEREIGN FINANCIAL CRISES
   FOLLOWED BY CONTAGION AND
   SYSTEMIC RISK CANNOT BE RULED
   OUT
---------------------------------------------------------- Chapter 2:1

The possibility of contagion and systemic risk in a future sovereign
financial crisis cannot be ruled out.  Broader and stronger linkages
between international and domestic financial markets mean that crises
can erupt much more quickly in today's markets and can be far larger
in scope than in the past, according to the G-10.  Factors that
indicate a potential for sovereign financial crises with contagion
and systemic risk include, among others, continuing large funds flows
into emerging market countries, which may amplify the magnitude of
financial crises and various trends that may contribute to volatility
in the flow of funds.  Factors that may lessen the likelihood of a
sovereign financial crisis leading to contagion and systemic risk
include, among others, recent changes in the composition of
investment flows to emerging market countries, a decrease in
potentially volatile portfolio investment funds flowing to emerging
market countries, decreased reliance on commercial bank lending, and
a greater diversity in the sources of investment. 


      FACTORS THAT MAY INCREASE
      THE LIKELIHOOD OF SOVEREIGN
      FINANCIAL CRISES THREATENING
      THE INTERNATIONAL FINANCIAL
      SYSTEM
-------------------------------------------------------- Chapter 2:1.1

We identified some capital market trends in emerging market countries
that may increase the risk of sovereign financial crises that
threaten the international financial system. 


         LARGE FUNDS FLOWS
         CONTINUE TO GO TO
         EMERGING MARKET ECONOMIES
------------------------------------------------------ Chapter 2:1.1.1

Investors have been attracted to opportunities in the developing
world.  Flows of capital to emerging market economies in the form of
purchases of securities have increased greatly in size over the
years, according to the G-10.  Despite the serious disruptions in
early 1995 as a result of the Mexican crisis, total net capital
flows--both public and private--to developing countries and countries
in transition reached a record $228 billion in 1995.  According to
the G-10, economic liberalization and reform in the developing world
have greatly increased the size and volatility of cross-border
investments.  The G-10 has stated that emerging market countries have
a firmer grasp on fiscal conditions and, in many emerging market
countries, inflation is coming under control.  For example,
macroeconomic reforms in the early 1990s in Latin America have led to
soaring private capital flows, according to a senior U.S.  Treasury
official.  Financial deregulation by country regulators has led to
the opening up of domestic financial markets, to borrowing and
lending abroad, to the development of stock markets, and to
invitations to foreign investors to participate as well as
diminishing capital controls.\1 Monetary policies in many creditor
countries have led to lower interest rates in those countries, which
then stimulated investors to search for higher yields abroad. 

Large funds flows into emerging market countries may amplify the
magnitude of financial crises, contagion, and any effect on the
international financial system.  Total net private capital inflows to
emerging market countries increased by threefold between 1990 and
1996, from about $60.1 billion to about $193.6 billion, with the
largest increase taking place between 1990 and 1991.  (See fig. 
2.1.) A Treasury official told us that countries are more able to
finance large current account\2 deficits than in the past because
private capital is now much more readily available. 

   Figure 2.1:  Net Private
   Capital Inflows to Emerging
   Market Countries (1990-96)

   (See figure in printed
   edition.)

Source:  IMF. 

Net private capital inflows include net portfolio investment, net
direct investment, and other net flows, including short- and
long-term trade credits, loans, currency and deposits, and other
accounts receivable and payable.  Net capital inflows for the years
1985-89 were about $40.6 billion, $50.4 billion, $48.7 billion, $40.1
billion, and $59.1 billion, respectively. 


--------------------
\1 Capital controls are limits placed by countries on cross-border
capital flows.  Capital controls may limit the types of flows that
come into or out of a country as well as limit the speed at which
funds can enter or exit a country. 

\2 A country's current account measures its transactions with other
countries' transactions, services, investment income, and other
transfers. 


         MUTUAL FUND MANAGER
         CONSTRAINTS
------------------------------------------------------ Chapter 2:1.1.2

Emerging market mutual funds--institutional investors with a
fiduciary responsibility\3 to shareholders--are an increasing source
of funds for borrowers in emerging market economies.  Fund managers
are expanding their portfolios into new markets.  As of September
1995, mutual funds dedicated to emerging market equities alone had
about $100 billion of securities in their portfolios.  Because fund
investment guidelines require mutual fund accounts to hold liquid or
marketable assets, fund managers may immediately attempt to dispose
of assets in a crisis, thus contributing to volatility in capital
markets. 


--------------------
\3 Fiduciary responsibility is the responsibility to invest money
wisely for the beneficiaries' benefit. 


         ELIMINATION OF CAPITAL
         CONTROLS
------------------------------------------------------ Chapter 2:1.1.3

A trend toward the elimination of capital controls in emerging market
countries is allowing investor funds to move more quickly in and out
of countries.  Such movement can increase the amount of funds that
can be withdrawn suddenly from a country when financial problems
become apparent.  The capital controls that are being eliminated were
imposed by individual countries and were intended to limit the kinds
of funds coming out of a country and the speed with which the funds
could leave a country.  One concern was that the funds withdrawn
quickly could put downward pressure on asset prices and have a
destabilizing effect on the countries' financial markets.  Despite
the appeal of (1) capital controls as speed bumps to dampen inflows,
(2) taxes, and (3) other measures to transform short-term volatile
money into long-term secure investment, the experience with capital
controls suggests that the economic distortions and macroeconomic
costs induced by controls are more costly than the potential
benefits, according to a senior Treasury official. 


         LIQUIDATION OF MORE
         DIVERSE INVESTMENTS
------------------------------------------------------ Chapter 2:1.1.4

According to the G-10, emerging market country external investments
are widening beyond debt into a whole array of assets--including
domestic bank certificates of deposit, government debt denominated in
local currency, and portfolio equities--none of which was significant
in the 1980s.  In countries that allow local currency to be freely
converted into foreign currency and withdrawn from the country, the
financial instruments may be sold for local currency, converted to
foreign currency, and transferred abroad.  These activities further
increase the amount of investment in a country that can be removed
quickly from a country. 


         BANK LINES OF CREDIT AND
         LIABILITIES
------------------------------------------------------ Chapter 2:1.1.5

Banks in emerging market countries may have extensive
foreign-currency-denominated international interbank lines of credit
as well as large liabilities to foreign nonbanks.  In times of
diminishing confidence, banks may have difficulty refinancing these
credit lines and liabilities, which can harm the banks' financial
positions.  Foreign currency lending to domestic borrowers can add to
the scale of a banking crisis when a devaluation makes it more
expensive for borrowers and banks to acquire the foreign currency
necessary to repay the loans.  Also, maturity mismatches may take
place when bank funding for long-term projects is drawn from
short-term deposits. 


      FACTORS THAT MAY LESSEN THE
      LIKELIHOOD OF SOVEREIGN
      FINANCIAL CRISES THREATENING
      THE INTERNATIONAL FINANCIAL
      SYSTEM
-------------------------------------------------------- Chapter 2:1.2

A study by an association of commercial banks, investment banks, and
other financial institutions; multinational firms; and trading
companies concluded that the risk of sustained contagion from a
sovereign financial crisis is small because the international
financial system appears relatively immune to systemic defaults by
emerging market countries.\4 The report states that severely adverse
economic conditions on a global scale were required to precipitate
the international bond defaults of the 1930s and the Latin American
debt crisis of the 1980s, and that the probability of similar
conditions is low in the medium term. 


--------------------
\4 Resolving Sovereign Financial Crises, Institute of International
Finance, Inc.  (Sept.  1996).  The study also noted that no contagion
ensued when Venezuela, the fourth largest debtor country in Latin
America, fell into arrears to private creditors and lost ready access
to international capital markets in 1995. 


         CHANGING FUNDS FLOWS
------------------------------------------------------ Chapter 2:1.2.1

The composition of funds flows to emerging market countries has
changed since Mexico's recent crisis, with a drop in portfolio
investment in emerging market countries.  Portfolio investment in
emerging market countries fell sharply--from about $89.3 billion in
1993 to about $44.5 billion in 1996.  (See fig.  2.2.) According to
some international financial experts, direct investment\5 tends to be
more stable and less likely to be withdrawn quickly.  Much direct
investment appears to be motivated by multinational corporations'
locating production facilities in countries with low labor costs. 
Federal Reserve officials told us that the recent decrease of
portfolio investments in emerging market countries may be transient
and not sustainable over time. 

   Figure 2.2:  Net Portfolio
   Investment and Foreign Direct
   Investment in Emerging Market
   Countries (1990-96)

   (See figure in printed
   edition.)

Source:  IMF. 

Net portfolio investment for the years 1985-89 was about $5.1
billion, $1.4 billion, $5.2 billion, $1.8 billion, and $10.3 billion,
respectively.  Net foreign direct investment for years 1985-89 was
about $8.6 billion, $8.6 billion, $12.1 billion, $17.6 billion, and
$20.4 billion, respectively. 

The pattern of these capital flows changed in 1995, with a larger
share going to those countries that had stronger economic
fundamentals--including more open investment climates.\6 These trends
indicate that investors began to be more aware of the risks of
investing in emerging market countries than they were before Mexico's
1994-95 crisis, according to the report. 


--------------------
\5 Foreign direct investment implies that a person in one country has
a lasting interest in and a degree of influence over the management
of a business enterprise in another country. 

\6 World Debt Tables:  External Finance for Developing Countries,
1996, World Bank, Volume One (Washington, D.C.). 


         DECREASED RELIANCE ON
         COMMERCIAL BANK LENDING
         AND A GREATER DIVERSITY
         OF INVESTORS
------------------------------------------------------ Chapter 2:1.2.2

Commercial bank lending to sovereign borrowers has been decreasing
relative to loans to private firms, according to several
international financial experts.  As syndicated long-term loans from
banks to country governments have fallen, bonds and foreign holdings
of domestic currency debt have risen, and short-term bank credits
have risen along with trade.  Diminished sovereign reliance on
commercial bank lending means less commercial bank exposure and less
of an impact on these banks if countries have difficulty servicing
their debt obligations.  Also, commercial bank loan portfolios in the
1990s have become more diversified and do not contain large
proportions of loans to emerging market governments as they did in
the 1980s, according to a commercial bank official. 


         MORE VARIED INVESTOR BASE
------------------------------------------------------ Chapter 2:1.2.3

According to the G-10 and the Institute of International Finance,
emerging market debt and equity is more widely held by a more varied
investor base--including insurance companies, pension funds, and
mutual funds.  A more diverse investor base means that any sovereign
debt-servicing problem would affect a wider variety of market
participants than was the case in the 1980s when commercial banks
were the dominant providers of funds for developing countries.  But a
more diverse investment base also means that the effects of a failure
of any individual creditor financial institution would be small. 
Thus, losses would be more easily absorbed and unserviceable debt
more easily written down without threatening the health of creditor
country financial institutions, as was the case in the 1980s.\7

Given these factors, it is unclear whether the likelihood of a
sovereign financial crisis in emerging market countries that leads to
substantial contagion to other countries has increased or decreased. 
However, World Bank officials told us that the global economy in the
1990s has not been tested by the major economic or financial shocks
that occurred in previous decades, such as the sudden oil price
increases in the 1970s.  Such shocks have contributed to past waves
of sovereign financial crises.  Furthermore, even in the absence of
shocks to the global economy, the composition and direction of
investment flows to emerging market countries and economic conditions
within those countries can change, sometimes rapidly and
unexpectedly, as can investor behavior in a crisis.  For these
reasons, we find no basis to rule out the possibility of future
sovereign financial crises' having substantial contagion effects on
other sovereign economies that might, in turn, threaten the stability
of the international financial system.  Treasury officials told us
that the likelihood of sovereign financial crises is greater now than
in the past because of increased capital flows to developing
countries, increased volatility of those flows, and the growing
ability of countries to run large current account deficits because
private markets will finance the deficits.  They also said that these
factors may produce crises whose containment would require more
substantial official sector resources. 


--------------------
\7 Financial Crisis Management:  Four Financial Crises in the 1980s
(GAO/GGD-97-96, May 1997). 


   VARIOUS MECHANISMS CAN HELP
   ANTICIPATE, AVOID, AND RESOLVE
   SOVEREIGN FINANCIAL CRISES
---------------------------------------------------------- Chapter 2:2

A variety of public and private sector mechanisms can help capital
market participants anticipate, avoid, and resolve sovereign
financial crises.  Major mechanisms that can help anticipate and
avoid such crises include the following: 

  -- debtor countries' governments can retain investor confidence by
     using the appropriate monetary, fiscal, debt management, and
     exchange rate policies;

  -- debtor countries' governments can provide information about
     their economic and financial situations;

  -- investors' avoiding or selling country-related financial
     instruments can signal emerging market countries' governments
     that their policies are inappropriate or unsound; and

  -- international financial institution and industrialized country
     governments can provide economic monitoring and advisory
     activities to debtor countries. 

Major mechanisms to help resolve sovereign financial crises include
the following: 

  -- IMF and industrialized countries can provide financial
     assistance and

  -- debtor countries and their creditors (either official creditors
     or commercial bank creditors) can use existing conventions for
     negotiations between them. 


      DEBTOR COUNTRY GOVERNMENTS'
      POLICIES AND INVESTOR
      BEHAVIOR CAN HELP AVOID
      SOVEREIGN FINANCIAL CRISES
-------------------------------------------------------- Chapter 2:2.1

Debtor country macroeconomic, financial, and exchange rate policies
that attract investment and promote investor confidence are the best
safeguards against sovereign financial crises, according to several
international financial experts we interviewed.  In their views,
policies that can enable a country to attract and hold portfolio
investment flows are generally those policies that maintain low
inflation, small or declining fiscal deficits, few restrictions on
capital movements into and out of the country, a prudent debt
management strategy, and a flexible foreign exchange system that
allows the country's authorities some macroeconomic policy
flexibility in the setting of interest rates.  A country's ability to
maintain such policies depends in part on its ability to maintain
domestic political support for the policies and on the strength of
its commercial banking system.  Political stability can also
influence investor confidence in a country.  Also, structural
weaknesses in the banking systems of debtor countries can seriously
aggravate sovereign liquidity crises, according to the G-10. 

Investor behavior can also help in the avoidance of sovereign
financial crises, according to some international financial experts. 
Investors can influence countries to adopt policies that they believe
to be sound by insisting on lending to countries with unsound or
inappropriate policies only at higher interest rates.  The increase
in the cost of borrowing, along with the possibility that investors
may stop lending funds altogether, can provide the incentive for a
country's authorities to correct their policies, which could help
avoid a sovereign financial crisis.  This investor behavior and
country reactions are forms of market discipline.  If the authorities
of the country wanted to continue to borrow in international capital
markets without substantial risk premiums, they would have to alter
those policies to reassure investors.  To the extent that debtor
countries and investors expect official sector intervention in the
event of problems, this market discipline can be undermined. 


      IMF AND CREDITOR COUNTRY
      GOVERNMENTS USE SURVEILLANCE
      TO HELP AVOID FINANCIAL
      PROBLEMS
-------------------------------------------------------- Chapter 2:2.2

International financial institutions, such as IMF and the governments
of the G-10 countries, also play a role in anticipating and avoiding
financial crises in emerging market countries.  Among international
financial institutions,\8 IMF plays a major role in monitoring
country economic and financial situations.  The Executive Board
requires the organization to (1) conduct "firm surveillance" over the
exchange rate policies of member countries and (2) adopt specific
principles for the guidance of all members with respect to those
policies.\9 IMF surveillance procedures include examining the
macroeconomic and related structural policies of individual
countries, assessing the consequences of individual countries'
policies for both the country and the operation of the global
financial system, and encouraging countries to adopt policies that
improve their financial and economic situation as well as enhance the
functioning of the international monetary system. 

IMF's Articles of Agreement requires it to conduct a variety of
surveillance and oversight activities.  The two principal activities
are regular consultations with member countries, which are known as
"Article IV consultations" because they are related to Article IV of
IMF's Articles of Agreement, and multilateral discussions with
countries' officials to be held twice yearly as part of IMF's
preparation of its World Economic Outlook reports. 

Article IV consultations typically involve an annual visit to the
member country by IMF staff.  During that visit, the IMF staff are to
confidentially consult with the country's officials on how effective
their economic policies have been during the previous year and what
changes might be anticipated during the coming year.  The IMF staff
are then to prepare a nonpublic report on their findings, which is to
be reviewed by IMF's Executive Board.\10 The Board's discussion of
the IMF staff's findings, with country representatives present, is to
constitute the Article IV consultation with the member. 

IMF's World Economic Outlook reports are to be issued twice yearly. 
The reports contain IMF staff economists' analysis of global economic
developments during the near term and medium term, with separate
report chapters devoted to, among other topics, an overview of the
world economy and issues affecting both industrial and developing
countries.  These reports, and the IMF staff studies that support
them, are publicly available from IMF.  The reports provide the basis
for multilateral economic outlook discussions at the Group of Seven
countries' meetings. 

Other tools of IMF surveillance include reviews of international
capital market developments, which are to result in annual public
reports,\11 and informal Executive Board sessions on world economic
and market developments, which are held about every 6 weeks,
according to an IMF document.  Under IMF policy, IMF's Executive
Board is to review the principles and procedures that guide its
surveillance every 2 years, to see if any changes are needed.  The
latest such review, which covered the 2 years following Mexico's
recent crisis, was completed in early 1997, according to an IMF
official. 

Some major industrialized countries also monitor the economic and
financial situations of debtor countries.  These industrialized
countries analyze the economic and financial situations and policies
of emerging market countries in which they have substantial
interests, such as trade or security interests, and suggest policy
changes to country officials when incipient problems are detected. 
In the case of the United States, reports from the U.S.  embassy are
to be sent to Treasury and the Department of State in Washington,
D.C.  Some monitoring may take place from the capitals of creditor
countries or at international conferences where debtor countries may
describe and discuss their economic policies.  Policy advice to
countries may be delivered in multilateral forums or in bilateral
meetings with the countries' heads of state or officials from other
parts of the governments, such as the finance ministry or central
bank. 


--------------------
\8 Other international financial institutions include the World Bank
and the Bank for International Settlements. 

\9 Articles of Agreement, International Monetary Fund, Article IV,
Section 3(b). 

\10 A recent IMF Executive Board decision provides for voluntary
release of factual information after the conclusion of an Article IV
consultation.  This release would provide information on the member
country's economy and IMF's assessment.  IMF's assessment is to
reflect the Executive Board's discussion of the nonpublic staff
report prepared before the Article IV consultation. 

\11 International Capital Markets:  Developments, Prospects, and Key
Policy Issues, Takatoshi Ito and David Folkerts-Landau, IMF
(Washington, D.C.:  Sept.  1996). 


      IMF FINANCING CAN HELP
      RESOLVE CRISES
-------------------------------------------------------- Chapter 2:2.3

IMF member debtor countries that cannot meet their financial
obligations and that find capital markets or sovereign lenders
unwilling to provide new financing, can ask IMF for financial
assistance.  IMF financial assistance is intended to provide the
country, over the short term, with sufficient foreign currency to
continue to service its debts, restructure its economy, stabilize its
currency, and maintain the necessary trade flows.  As of the fall of
1995, about 60 countries were receiving assistance from IMF, and
about 20 other countries were actively negotiating with IMF for
assistance.  Most IMF programs are in the form of loans that are not
financed through quota resources.  Crisis resolution funding would
usually be undertaken through quota resources.  As of May 1997, there
were 34 loan arrangements and 25 programs funded through quota
resources. 

IMF member countries with balance-of-payments problems ordinarily are
allowed to withdraw,\12 without policy conditions, up to 25 percent
of the funds that they contribute to IMF, according to IMF documents. 
That is, countries may withdraw funds without performance criteria or
phasing of disbursements.  Member countries that want additional IMF
credit are subject to these conditions.  A member country that needs
more than 25 percent of its contribution may request more funds from
IMF and may borrow cumulatively up to 3 times its contribution in any
one year or 300 percent, cumulatively.  IMF policy allows a country
to exceed this maximum level of borrowing in extraordinary or
exceptional circumstances.  IMF determined that such extraordinary
circumstances existed when IMF made available about 688 percent of
Mexico's contribution in 1995.\13 Countries that borrow from IMF are
expected to repay the borrowed funds as soon as they resolve their
payments problem.  Before IMF will agree to extend financing, the
country seeking assistance has to demonstrate how the funds will be
used to solve its payments problem, thereby providing for repayment
of the funds within 3 to 5 years, according to IMF documents. 

To ensure that the member country uses the borrowed funds
effectively, IMF financing arrangements require borrowing countries
to (1) undertake a series of economic and other policy
reforms--called "conditionality"--that are intended to eradicate the
source of the payments difficulty, (2) lay a firmer foundation for
economic growth, and (3) ensure that the country will be able to
repay the funds in a short period, according to IMF documents.  In
some cases, these conditions are quite stringent and politically
difficult for countries to implement.  Policy commitments of the
member country government are embodied in a letter of intent, which
is the outcome of policy discussions between IMF staff and the member
country government.  Policy commitments embody performance criteria
focusing on budgetary and credit ceilings, reserve and debt targets,
and avoidance of restrictions on payments and transfers.  Typically,
countries applying for IMF financing present IMF with a reform plan
to lower the value of their currency, encourage exports, and reduce
government expenditure.  IMF Executive Directors are to determine
both the sufficiency of the reform measures and whether IMF can
reasonably expect repayment.  Following the approval of IMF Executive
Directors, the loan is to be disbursed in installments--usually over
1 to 3 years--and disbursements are tied to the borrowing member's
progress in implementing the planned reforms.  Borrowing members pay
charges to cover IMF expenses and to compensate the member whose
currency it is borrowing.  As of May 1996, borrowers pay commitment
fees of 0.5 to 1 percent and interest charges of about 4 percent. 

Different types of IMF financing arrangements are available to
address various balance-of-payments problems.\14 IMF can provide this
assistance before debt-servicing problems arise.  The most common
arrangement, which is called a "standby arrangement," is to be
provided to a member country that is having trouble staying current
in its foreign obligations and is to be a conditional line of credit
for up to 3 years that allows the country to reorganize its finances. 
Standby arrangements typically focus on macroeconomic policies, such
as fiscal, monetary, and exchange rate policies.  If conditions are
not met, access to further drawings is to be interrupted.  Another
IMF facility makes funds available at low interest rates to poor
nations.  Loans under this facility, which is administered separately
from regular IMF resources, require close cooperation with the World
Bank and its programs for economic development of the world's poorest
nations. 

IMF generally has not lent to a country until the country reached
agreements to settle debt claims of creditors in both the private and
official sectors; in other words, IMF has seldom "lent into arrears,"
according to IMF documents.  However, IMF has made exceptions to this
policy, particularly after 1987.  At that time, IMF relaxed
conditions attached to its own disbursements, thereby making
disbursements before the country had reached agreements with banks
and approving adjustment packages that involved less than full
payment to banks.  This policy change was intended as a means of
inducing commercial banks to conclude negotiations with debtor
countries.  The purpose of the policy change was to shift bargaining
power in debt negotiations from the commercial banks to debtor
countries and to hasten resolution of debt crises, according to IMF
documents. 


--------------------
\12 Member withdrawals are purchases of SDRs or convertible
currencies with their own currencies. 

\13 Current rules permit an IMF member to borrow an amount equal to
100 percent of its quota per year, with a cumulative limit of 300
percent, unless exceptional circumstances exist.  IMF potential
lending to Mexico was about 688 percent of Mexico's quota over an
18-month period or 459 percent of its quota on an annual basis. 

\14 Other facilities include the extended fund facility, which makes
credit available for longer periods of time; the systemic
transformation facility for economies in transition from centrally
planned to market-based systems; the structural adjustment facility
to support macroeconomic adjustments and structural reforms in
low-income countries; and other facilities. 


      U.S.  INITIATIVES AND
      FINANCIAL ASSISTANCE CAN
      HELP RESOLVE CRISES
-------------------------------------------------------- Chapter 2:2.4

The U.S.  government has worked both directly and indirectly with
debtor countries to help resolve sovereign financial crises.  To
stabilize foreign exchange markets, the United States has provided
currency swaps to emerging market countries through Treasury's
Exchange Stabilization Fund and the Federal Reserve's currency swap
network. 

Also, the U.S.  government has two initiatives that it has used to
deal in general with the problem of developing country debt.\15 In
1985, the United States used the Baker plan to try to revive economic
growth in developing countries by arranging for debtors to borrow
even more funds from both private commercial banks and multilateral
development banks.  In 1989, the United States, recognizing that
these debtors could not fully service their debts and restore growth
at the same time, used the Brady plan to seek permanent reductions in
the debtors' existing commercial debt-servicing obligations.  Under
the Brady plan, Mexico's government reduced its debt-servicing burden
to commercial banks by reducing its stock of debt, lengthening
maturity, and lowering interest payments.\16 Creditor countries may
also help resolve sovereign financial crises less directly, by
working within existing conventions for negotiating settlement of
debts. 


--------------------
\15 Since each initiative was launched by a Secretary of the
Treasury, the plans bear each Secretary's last name. 

\16 Mexico's bank loans were converted into new bonds--with reduced
principal or reduced interest rates. 


      EXISTING CONVENTIONS FOR
      NEGOTIATING SETTLEMENT OF
      DEBTS CAN HELP RESOLVE
      SOVEREIGN FINANCIAL CRISES
-------------------------------------------------------- Chapter 2:2.5

In some cases, developing countries have been unable to meet their
financial obligations.  A country with debt-servicing problems
typically may suspend payments and obtain legal representation to
protect the country from its creditors and to help it negotiate a
settlement with those creditors.  An indebted country sometimes has
lacked a clear understanding of its true debt situation and its
ability to pay those debts and would seek assistance from IMF or a
private firm employed to advise the country.  According to our
analysis, the country's creditors would either sell the country's
debt to other investors, accepting any losses incurred, or prepare
for negotiations with the country by assessing the country's debt
situation and its ability to pay those debts.  The indebted country
would have multiple objectives in these negotiations, including
rescheduling some or all of its debts or having debts forgiven;
continuing the normal operation of its economy; maintaining political
stability; preserving an adequate level of foreign currency reserves;
and hastening a reestablishment of access to international capital
markets, according to an international legal expert.  Creditors would
seek to maximize the amount of money they may receive by minimizing
changes to the terms and conditions of the debt--except for interest
payments, which they would usually try to increase. 

The negotiations have often been conducted using existing conventions
that have evolved to help resolve actual or imminent sovereign
defaults.  One mechanism, known as the Paris Club, has been used to
facilitate negotiations for bilateral official credits or debts owed
to governments--usually governments of industrialized countries.  A
second mechanism, known as the London Club, has been used to
facilitate negotiations for debts owed to commercial banks.\17

The Paris Club is a forum established in the 1950s for the
rescheduling or refinancing of credits issued, guaranteed, or insured
by creditor country governments.  Although it is not a formal
institution but rather an informal group of creditor country
governments, the Paris Club operates according to an agreed-upon set
of policies and procedures.  There is no international statutory law
that governs these policies and procedures.  The Paris Club's
membership has been determined on a case-by-case basis; however, its
membership always has included the G-7 countries and often has
included some of the other larger industrialized countries. 

An indebted country applies to the Paris Club to negotiate the
rescheduling or refinancing of debts it cannot pay.  IMF has been
integrally involved in Paris Club negotiations.  Indeed, an IMF
forecast showing that a country cannot meet its debt-service
obligation is a precondition of opening a Paris Club negotiation. 
Furthermore, the Paris Club has required the debtor country to
conclude an agreement with IMF that specifies policy reforms the
country must make before rescheduling negotiations may begin.  Paris
Club negotiations have generally taken about 6 to 8 months but some
cases have evolved into long, drawn-out negotiations.  Paris Club
negotiations culminate in a nonbinding understanding that provides
the framework within which individual creditors conclude binding
agreements with the debtor.  This framework is intended to ensure
that no creditor receives preferential treatment. 

The London Club, which first was used in 1976, is a framework for
negotiating the rescheduling of credits extended by commercial banks
to governments, central banks, and other public sector institutions. 
Like the Paris Club, the London Club is a set of conventions, rather
than an institution.  The London Club has no fixed venue or
secretariat but rather a body of procedures and conventions
extablished by precedents.  The participants in these negotiations
vary with the commercial banks that have extended credits and are
exposed to losses.  Commercial banks participating in London Club
negotiations form a steering committee of typically 15 members, each
of which represents a number of other creditor banks.  These creditor
banks tend to be more numerous than the sovereign creditors involved
in Paris Club negotiations.  This steering committee makes its own
forecast of the country's ability to repay its debts and negotiates
policy changes that the country is to make as a condition of the
rescheduling.  In the past, these commercial banks have relied on IMF
to monitor countries' adherence to the policy conditionality, and the
banks have insisted on some form of IMF "seal of approval" before
conducting a restructuring.  In practice, the banks, sovereign
creditors, and IMF all engage in negotiations about the share and
nature of debt relief each will grant to the debtor country. 

In London Club negotiations, agreements between the debtor country
and the commercial banks' steering committee can be approved by banks
holding 90 to 95 percent of total bank exposure to loan losses. 
Banks on the steering committee must at each stage of the agreement
get approval from the banks that they represent.  Often, each bank is
represented by its own legal counsel who must scrutinize all
agreements.  Dissenting banks and other entities are not compelled to
accept the agreements, and creditor banks or assignees of bank debt
can sue debtor countries for enforcement of the terms of the original
loan agreement.  Therefore, dissenters can hold up the negotiation
process until they are bought out by the debtor or other creditors. 
For this reason, London Club negotiations have been lengthy.  For
example, Poland required almost 14 years to complete its London Club
debt restructuring, which began in 1981. 

Venues such as the Paris or London Clubs do not exist for
renegotiating bonded debt.  Although defaults by sovereigns on
foreign-currency-denominated debt took place on a substantial scale
throughout the 19th century and as recently as the 1940s, since World
War II only a very small number of defaults by countries on
foreign-currency-denominated bonds have occurred although there have
been numerous sovereign debt-servicing problems, according to
international finance experts.  Negotiations to resolve these arrears
have been handled on a case-by-case basis, usually in conjunction
with settlements of other types of debts, such as commercial bank
loan debt.  During the 1930s, a wave of defaults occurred on
sovereign bonds, which was triggered by the Great Depression.  To
negotiate settlements of these defaults, bondholders organized into
committees.  These committees, with the support of the United States
and other creditor country governments, successfully negotiated
settlements with the affected countries' governments, although some
of these negotiations took years to complete. 


--------------------
\17 During the developing country debt crisis of the 1980s, the Paris
and London Clubs were the principal venues and forums for
negotiations between debtor countries, commercial bank creditors, and
the official sector. 


   MECHANISMS THAT CAN HELP
   ANTICIPATE AND AVOID SOVEREIGN
   FINANCIAL CRISES HAVE
   LIMITATIONS
---------------------------------------------------------- Chapter 2:3

The effectiveness of these public and private sector mechanisms to
anticipate, avoid, and resolve sovereign financial crises can face
various limitations.  These limitations include (1) moral hazard, (2)
inadequate public provision of information by borrowing countries,
(3) insufficient analysis by investors of the information that
countries do provide, (4) domestic obstacles that can prevent
countries from adopting appropriate economic and financial policies,
and (5) inadequate surveillance of countries' economic and financial
policies by IMF and creditor country governments. 


      DISTORTED INCENTIVES CAN
      UNDERMINE ANTICIPATION AND
      AVOIDANCE MECHANISMS
-------------------------------------------------------- Chapter 2:3.1

Some of the international financial experts we spoke with said that
the expectation that public authorities will insulate lenders and
borrowers from adverse consequences of their actions can entice
investors to lend and countries to borrow while inadequately
monitoring their risk.  This is known as moral hazard.  The presence
of moral hazard in a financial market can cause market discipline to
deteriorate and countries to prolong bad policies.  If official
sector intervention is expected, then investors are more likely to
purchase risky country debt.  Moral hazard can be a factor in
international financial markets, especially for portfolio investors,
because, unlike direct investors who may build production facilities
in other countries, portfolio investors may not have a permanent
stake in the country's financial health. 


      INFORMATION THAT COUNTRIES
      PROVIDE TO INVESTORS MAY BE
      INADEQUATE
-------------------------------------------------------- Chapter 2:3.2

The globalization of financial markets has increased the importance
of disclosure and the public reporting of sovereign economic and
financial data.  A regular and timely flow of relevant economic and
financial data plays a critical role in helping a country's
government develop and implement sound policies.  A regular flow of
accurate and timely economic and financial data to capital market
participants seems likely to promote the smooth functioning of
international capital markets.  One way that countries improve their
acceptability in capital markets is to publicly provide data.\18
Investors may use this information to assess the risk of investing in
countries and to help manage their investments.  The better a country
is in providing accurate and timely data, the better investors will
be able to assess the risks of investing in the country.  Some market
participants are not aware of all the information that is currently
available and do not adequately use the available information in the
investment analyses, according to the G-10.  Better risk assessments
can improve investors' abilities to identify countries with financial
problems, and the investors' behavior of avoiding or selling
investments in such countries may encourage the authorities of those
countries to make needed policy corrections.  In addition, IMF and
other international financial institutions and the governments of
major creditor countries can use this information for surveillance
purposes. 

Information problems may have contributed to Mexico's 1994-95
financial crisis.  An often-noted problem in Mexico's data reporting
in 1994 involved its infrequent reporting of foreign currency
reserves.  Specifically, before the crisis, Mexico reported the
foreign currency reserve holdings of its central bank only three
times annually.  Since Mexico's crisis, country data have
improved--in some cases, substantially--according to one analysis. 
The previously mentioned 1996 study\19 by an association of financial
companies found that, for 28 emerging market countries that received
the greatest share of funds flows to emerging market countries, the
adequacy of the data these countries supplied to markets had improved
since the 1994-95 Mexican crisis.  However, that same study found
that the reporting of certain data remained poor for many
countries--notably for external debt statistics. 


--------------------
\18 In some cases, countries supply these data only to companies that
specialize in assessing sovereign risk, and the companies then sell
their assessments to other businesses. 

\19 Resolving Sovereign Financial Crises, Institute of International
Finance, Inc.  (Sept.  1996). 


      INVESTORS MAY NOT USE
      AVAILABLE INFORMATION TO
      MONITOR RISKS
-------------------------------------------------------- Chapter 2:3.3

Companies that invest in emerging markets, including institutional
investors who invest their clients' funds, have a stake in accurately
estimating the risks of such investments.  Nevertheless, in some
cases, investors appeared to disregard or ignore available
information that may have helped them assess the chances of a
sovereign financial crisis. 

In Mexico's case, data on the buildup of the Mexican government's
short-term, dollar-linked debt were not widely publicized by the
Mexican government, but were available to investors, according to
numerous sources.  The differential between interest rates on Mexican
and U.S.  government securities indicated that during much of 1994,
financial markets perceived a low likelihood of Mexico's devaluing
its currency or having debt-servicing problems.  Between August and
October, 1994, this differential narrowed, which suggests that
markets believed that these risks were decreasing.  We know now that
the risks of a sovereign financial crisis were increasing during this
time period.  Representatives from some large, private investment
firms told us that, before Mexico's crisis, their firms' risk
assessment systems did not properly take into account short-term
capital flows and other liquidity considerations. 

According to some international finance experts, the following
factors may have affected international investors' willingness to
demand better and more timely information from Mexican authorities in
1994: 

  -- The increasing magnitude of funds available to managers of
     emerging market investment funds put pressure on them to invest
     in countries with high rates of return without adequately
     analyzing the risks of these investments. 

  -- Investors did not fully appreciate how quickly securitized
     investments could be removed from a country and, therefore, may
     have underestimated the importance of a regular flow of key data
     from Mexico. 

  -- Investors appeared to have had excessive faith in the ability of
     Mexico's leadership to change inadequate policies quickly. 

  -- The odds of a country's having debt-servicing problems or
     defaulting on any particular debt were generally low. 


      COUNTRIES MAY FACE DOMESTIC
      OBSTACLES TO ATTRACTIVE
      POLICIES
-------------------------------------------------------- Chapter 2:3.4

International financial experts have cited weak domestic commercial
banking systems as obstacles to policy changes that would retain
investor confidence in emerging market countries.  Banks are at the
center of economic and financial activity in emerging market
countries.  A well-functioning banking system is important for the
effectiveness of macroeconomic policies, and unstable macroeconomic
environments can make it difficult for banks to assess credit risk. 
A sound banking system is one that is able to withstand adverse
events and is a system in which most banks are solvent and likely to
remain so.  Solvent banks are profitable, well-managed, and
well-capitalized.  Even with many emerging market banks free of
government intervention, years of government control of banks and
inadequate competition left many banks unable to properly evaluate
credit risks in some countries, according to international banking
experts.  The IMF Managing Director has said that the Mexican crisis
demonstrated that countries with weak and inefficient banking systems
are more vulnerable to contagion and less able to manage the effects
of volatile capital flows and exchange rate pressures. 

Banking problems in emerging market economies can have serious
consequences for local economies and can spread to other countries,
according to international banking experts.  In some emerging market
countries, structural weaknesses in the banking system and inadequate
supervision and regulation of commercial banks have made the
countries vulnerable to financial crises and have seriously
aggravated such crises when they did occur. 

Since 1980, over 130 countries have experienced significant banking
sector problems.\20 Banking crises in emerging markets have usually
been more severe than in industrial countries.  Resolution costs or
losses from country banking crises have ranged from 3 percent of
gross domestic product\21 in industrial countries to more than 25
percent of gross domestic product in emerging market countries,
according to international banking experts. 

A legal system that facilitates bank supervision and regulation is
important for healthy emerging market banking systems.  The legal
system must facilitate bank seizures and the transfer of collateral
behind delinquent loans.  Bank supervisors that need to curtail
excessive risk-taking and limit bank rescue costs, need the statutory
authority to (1) issue and enforce sanctions, such as
cease-and-desist orders to banks; (2) specify accounting practices;
(3) and close insolvent banks. 

According to a study by a G-10 Working Party,\22 problems have arisen
when banks funded sizable amounts of long-term domestic lending with
short-term foreign currency borrowing in the wholesale interbank
markets of the main international financial centers.  According to
our analysis, this type of bank funding could act as a major
deterrent for a country to make a needed devaluation because a
devaluation, which increases the domestic currency value of a bank's
liabilities, might threaten bank insolvency.  Decisions by the
creditors of banks not to refinance such funding could generate a
banking crisis because emerging market governments may be constrained
from offering support to the banking system because the government's
own financial position could deteriorate significantly.  Such banking
problems may present emerging market governments with the prospect of
a large, public sector liability if these governments should take on
the bad debt of their banks. 

Also, bank operations in emerging market countries tend to suffer
from (1) poor accounting systems; (2) lack of implementation of
appropriate loan valuation and classification practices; (3)
nonadherence to the Basle risk-weighted capital standard; (4) lack of
limits on loans to bank owners and directors and bank-related
businesses; (5) lack of competition from new entrants; (6) bank loan
portfolios that are too concentrated by client base or geographic
region; (7) owners who do not share the risk to which they expose
their depositors; and (8) supervisory rules, if any, that do not
require regulators to impose remedial measures on banks as their
capital drops below specified levels, according to an international
banking expert.  Once a banking system becomes fragile, the host
country may feel constrained in using interest rates as an
equilibrating mechanism to deal with shifts in market sentiment by
raising interest rates because higher interest rates can harm banks
by raising the number of nonperforming loans on their books.  A weak
domestic banking system was part of the reason Mexican government
officials were reluctant to raise interest rates to continue to
attract investor flows. 

Poor oversight of emerging market banks has also been a problem,
according to international banking experts.  Supervisory guidelines
have been lax or easy to evade.  Resources have been inadequate to
monitor banks.  Lax entry standards have led to excessive expansion
and widespread subsequent failures.  Entry standards that create
competition among banks have been allowed in foreign banks that are
highly competitive and have reduced the overall profitability of
banks.  Supervisory authorities have not had the power to revoke bank
licenses.  Capital adequacy ratios have not been high enough to
safeguard bank assets.  Accounting and auditing standards have often
been lax and ill defined in the developing world.  Accurate
accounting practices have not included current and complete
recognition of nonperforming assets. 

International financial experts have also cited political
considerations as impediments to policy changes that would retain
investor confidence in emerging market countries.  Domestic political
opposition can block policy changes necessary to attract and maintain
investment.  Our report on Mexico's crisis found that such obstacles
occurred in Mexico in 1994.  Due in part to an upcoming presidential
election, Mexican authorities were reluctant to raise interest rates,
devalue the peso, or take other action that could have reduced the
inconsistency that had developed between Mexico's monetary and fiscal
policies and its exchange rate system. 


--------------------
\20 Banking Crises in Emerging Economies:  Origins and Policy
Options, Morris Goldstein and Philip Turner, Bank for International
Settlements (Basle, Switzerland:  Oct.  1996). 

\21 Gross domestic product is the total value of goods and services
produced in a country's economy in a year. 

\22 The Resolution of Sovereign Liquidity Crises, Group of Ten
(Basle, Switzerland:  May 1996). 


      ACTIVITIES OF IMF AND THE
      U.S.  GOVERNMENT CAN BE
      WEAKENED BY INADEQUATE
      INFORMATION
-------------------------------------------------------- Chapter 2:3.5

Mexico's 1994-95 financial crisis revealed inadequacies in IMF's
monitoring and advisory activities and in the U.S.  government's
monitoring of Mexico's situation.  Treasury and IMF officials told us
that IMF did not keep a close watch on developments in Mexico during
the latter half of 1994, did not see a compelling case for
devaluation before December 1994, and did not foresee the financial
crisis that occurred after Mexico's devaluation. 

According to an IMF official we interviewed, IMF commissioned a
postcrisis study,\23 which concluded that among the causes of the
deficiencies in IMF surveillance of Mexico were that IMF was not
monitoring countries on a real-time basis and IMF had become too
tolerant of a falloff in the quality and timeliness of data provided
by member countries that were no longer in an IMF-supported
adjustment program.  IMF public documents discussing the deficiencies
of IMF surveillance of Mexico provided more details about the
deficiencies.  According to these documents, Mexican authorities'
delays in reporting key data to IMF and reluctance in discussing
policy issues when difficulties became apparent were key elements of
the crisis.  Furthermore, according to these documents, certain
aspects of IMF's "culture," as well as IMF's close relationships with
its members, had contributed at times to less effective surveillance. 

A Treasury official we interviewed identified the following factors
that may also have contributed to deficiencies in IMF's monitoring of
Mexico: 

  -- IMF staff tended to give Mexico "the benefit of the doubt"
     because Mexico had a highly respected economic team. 

  -- IMF's Article IV consultation with Mexico took place early in
     1994, which was before Mexico faced obvious financial problems. 

  -- IMF staff were not paying enough attention to private market
     borrowing by countries. 

  -- IMF staff doing financial market analysis were working
     independently from IMF country teams. 

The U.S.  government was more aware than IMF of the deterioration of
Mexico's financial situation in 1994.  Treasury and Federal Reserve
officials monitored events in Mexico; by summer 1994, their analysts
had concluded that the peso was overvalued.  However, like IMF and
most financial market participants, U.S.  officials underestimated
the potential of a large amount of outstanding tesobonos to
precipitate an investor panic if Mexico unexpectedly devalued its
currency. 


--------------------
\23 In 1995, IMF commissioned a former senior IMF official to conduct
a postcrisis study to determine why IMF did not anticipate the
Mexican crisis.  We were unable to obtain a copy of the study from
IMF.  However, an IMF official discussed some of the study's
conclusions with us, and some of the study's findings have been
discussed in various IMF publications. 


   MECHANISMS THAT CAN HELP
   CONTAIN AND RESOLVE SOVEREIGN
   FINANCIAL CRISES HAVE
   LIMITATIONS
---------------------------------------------------------- Chapter 2:4

Once a country's financial difficulties become acute, investors may
overreact, precipitating or deepening a crisis, according to
international financial experts.  According to some financial
experts, governments and IMF may have difficulty deciding whether to
intervene to help resolve a sovereign financial crisis because
decisionmakers may disagree over (1) the extent of the threat a
crisis poses to the international financial system and (2) whether
such a threat warrants intervention, which may create additional
moral hazard.  Also, after an agreement to intervene has been
reached, creditor country governments and IMF may find it difficult
to provide sufficient financial assistance quickly enough to arrest
the crisis. 


      INVESTOR REACTIONS MAY
      PRECIPITATE OR DEEPEN A
      CRISIS
-------------------------------------------------------- Chapter 2:4.1

Investors in liquid securities that are confronted with uncertainty
have a strong incentive to sell their securities, according to
international finance experts.  Investors may react to news of a
country's deepening financial difficulties by selling their
country-related financial instruments, and thus precipitate a crisis
that would not have otherwise occurred or seriously aggravate a
crisis that already has begun.  In response to adverse information,
individual investors in a country may face powerful incentives to
liquidate their investments immediately, before other investors do
the same and cause the country to run out of funds to repay its
debts.  Individual investors have an incentive to sell their
investments even if the creditors would be better off as a group if
the investors continued to hold the debt of the country.  This
behavior may be more common with portfolio investment, such as mutual
and pension funds, because (1) investments in emerging market country
securities are usually more readily sold than direct investments,
such as production facilities, and (2) the managers of these funds
may have a fiduciary responsibility to sell poorly performing assets. 
Other investors, upon seeing funds exit a country, may interpret
these funds flows as evidence that the country is in serious
financial trouble.\24 If enough investors withdraw funds, what began
as a market disruption could quickly become a self-fulfilling crisis. 
Investors' overreaction to Mexico's crisis may have contributed to
the spread of the crisis to other countries, to the extent that
investors pulled funds out of other countries because investors
wrongly concluded that these countries faced problems similar to
Mexico's, according to international financial experts. 


--------------------
\24 According to bank regulators, the likelihood of a loss of
investor confidence is greater when investors know that a country's
banking system is weak, and that the country may have trouble
tolerating prolonged financial trouble. 


      NEGOTIATIONS MAY BE TROUBLED
      BY A SCARCITY OF INFORMATION
      AND NEGOTIATING STRATEGIES
-------------------------------------------------------- Chapter 2:4.2

Various obstacles to expeditiously resolving a sovereign financial
crisis may develop during the negotiations between a country that is
having debt-servicing problems and its creditors.  Two such obstacles
are a lack of information that creditors may use to verify claims
made by the debtor country, which may lead to delays in negotiations,
and delays in resolution due to creditor holdouts. 


         SCARCITY OF INFORMATION
         AND DELAYING TACTICS
------------------------------------------------------ Chapter 2:4.2.1

Creditors of a country that is having debt-servicing problems may not
have access to the information they need to verify the country's
financial situation and to independently estimate the country's
economic ability or political willingness to adopt economic reform
measures that would allow debts to be repaid, according to several
international finance experts.  In the case of a sovereign default or
difficulties with debt servicing, where the lending is not backed by
collateral, this information can be crucial in helping investors to
develop their negotiating positions.  Furthermore, when a country's
creditors have complex and conflicting claims, they may not believe
that it is in their interest to share key information among
themselves about a country's ability to honor its debts.  In
addition, debtor governments may be unsure of how much of a loss
bondholders are willing to accept.  In such an environment, both a
debtor country and its creditors can engage in strategic bargaining,
posturing, delaying tactics, and other actions that could prolong
negotiations to the detriment of one or both sides. 

There is evidence that efforts to resolve some past financial crisis
were troubled by these information-related problems.  For example, in
the 1930s, negotiations over defaulted Latin American bonds were
protracted, taking over a decade to complete in some cases, according
to an international finance expert.  This situation happened, in
part, because incomplete information problems led to strategic
bargaining and delaying tactics.  Also, according to this expert, in
the 1980s' developing country debt crises, creditor banks lacked key
information on the financial position of debtor countries, which also
prolonged negotiations and harmed both the banks and the debtor
countries.  This situation did not occur in Mexico in 1995 because
the multilateral financial assistance package prevented Mexico from
defaulting on any of its debts. 


         CREDITOR HOLDOUTS
------------------------------------------------------ Chapter 2:4.2.2

After a country reaches agreement with the majority of its creditors,
a final problem can develop:  a small number of creditors, seeking to
maximize their returns and hoping to be bought out by larger
creditors, can block the settlement.  This occurred in the 1980s'
developing country debt crisis, according to an IMF official, when a
small number of banks involved in syndicated loans to developing
countries held out and delayed settlements that had been reached by
the majority of banks involved in the loans.  Most bond contracts
require unanimous approval of bondholders to alter the bonds' core
provisions, which also creates a potential holdout problem for bond
debts. 


      DEBTOR COUNTRIES MAY BE
      UNABLE TO ATTRACT NEW FUNDS
-------------------------------------------------------- Chapter 2:4.3

Another problem that can develop in capital markets involves the
provision of new money to a country with debt-servicing problems,
according to international financial experts.  Often a country
experiencing a financial crisis requires new money to restructure its
old debts or to allow the adoption of policy changes that are
necessary to aid its ability to pay its debts.  Yet, these investors,
who are concerned about liquidity, have a disincentive to providing
additional funds to a country, largely because they would be
concerned that any new funds they supply would be used--at least in
part--to pay off old creditors.  New funds were needed in Mexico's
1982 and 1994-95 financial crises.  In 1982, commercial banks and
others provided new funds; in 1995, new funds came from the U.S. 
government, IMF, and Canada. 

Organizing the provision of new funds to an indebted country can be
particularly difficult in the case of bond financing, where it is
necessary to coordinate the actions of a large number of debt
holders.  Another reason it can be difficult to organize the
provision of new funds is that bondholders--with their concern for
rates of return and liquidity--are less likely to see an advantage in
a long-term lending relationship than are banks or direct equity
investors.  Both the 1930s' bond negotiations and the 1980s' debt
crisis were prolonged due to creditor reluctance to provide new
money. 


      GOVERNMENTS AND IMF MAY HAVE
      TROUBLE HELPING TO RESOLVE
      CRISES
-------------------------------------------------------- Chapter 2:4.4

Our analysis showed that governments of creditor countries and IMF
may be limited in their abilities to respond to sovereign financial
crises.  The governments of leading creditor countries lack
procedures for responding to a crisis in an emerging market country,
according to an international financial expert.  Policy disagreements
within a country's government or between countries over whether a
country's financial crisis will lead to contagion or systemic risk
problems can impede the speed with which creditor countries and IMF
respond.  Disagreements may also arise about whether the threat posed
by the crisis warrants intervention that may alter future incentives
for investors and countries.  A consensus was not achieved among
major creditor countries that Mexico's 1994-95 financial crisis posed
systemic risk, according to international financial experts. 
Officials disagreed about whether there was a threat to banking
systems in countries other than Mexico and whether Mexico's problems
would result in a shock to nondepository financial institutions
around the world.  Creditor countries also disagreed about the risk
to economic activity around the world and the risk to the global
trend toward market-oriented reforms.  The German and Japanese
governments were concerned that official assistance to emerging
market countries would encourage reckless lending and overborrowing. 

Debates on the use of resources of creditor countries and IMF can
also hinder the speed of country response to sovereign financial
crises.  In Mexico's recent financial crisis, the United States'
response was slowed by policy disagreements between the executive
branch and Congress.  After an initial financial assistance package
failed to receive sufficient congressional support, the Exchange
Stabilization Fund and the Federal Reserve swap network was used to
assist Mexico.  Use of the Exchange Stabilization Fund does not
require the consent of Congress. 

Individual countries also may find it difficult to provide the
financial resources necessary to respond to a financial crisis.  The
United States can respond to some degree to sovereign financial
crises with the resources of the Exchange Stabilization Fund and the
Federal Reserve swap network.  As of September 30, 1996, the Exchange
Stabilization Fund had the equivalent of $38 billion in Japanese yen,
German marks, special drawing rights, and dollars.  The Federal
Reserve swap network has various reciprocal currency arrangements
available to different countries.  To the extent that the resources
of the Exchange Stabilization Fund are not already being used in
helping countries that are currently experiencing financial crises,
the Fund could be available for assisting additional countries in
trouble.  Other potential creditor countries may not have the legal
authority or resources to provide assistance to countries
experiencing financial crises. 

The ability of IMF to respond to a sovereign financial crisis is also
dependent upon its available resources.  IMF's various resources for
assisting countries in trouble may at any given time already be
committed.  If this is the case, according to our analysis, IMF
options would include asking for additional funds from its members,
suggesting that debtor countries ask individual countries or other
organizations for assistance, or telling the debtor country that IMF
resources are not available and that no assistance will be
forthcoming. 

Individual countries and IMF may find it even more difficult to
provide the magnitude of financial resources that would be necessary
to respond to multiple, simultaneous sovereign financial crises. 
Simultaneous sovereign financial crises may be beyond the available
resources of the United States and IMF--especially if the countries
in crisis are large emerging market economies. 


INITIATIVES COULD HELP STRENGTHEN
CRISIS ANTICIPATION AND AVOIDANCE,
BUT OBSTACLES TO SUCCESS EXIST
============================================================ Chapter 3

International financial institutions and governments of the
industrial democracies have three principal initiatives under way to
help anticipate and avoid sovereign financial crises.  These
initiatives are market-based efforts to address weaknesses in
mechanisms to anticipate and avoid sovereign financial crises.  Our
analysis indicated that, while these initiatives appear to have the
potential to contribute to helping countries and their creditors
anticipate and avoid some future sovereign financial crises,
significant obstacles could hinder their full effectiveness. 

One G-7 initiative is IMF's effort to promote the provision of more
reliable and complete information for investors and others by
borrowing countries.  IMF developed a voluntary standard that
countries may use in disclosing economic and financial data to the
public.  IMF has said that it expects countries that subscribe to the
standard will comply with its requirements, and has stated its
intention that IMF will remove nonadhering countries from the list of
subscribing countries.  However, no ready means exist to monitor
countries' adherence to the standard. 

A second initiative, which was put forward by a G-10 Working Party
and, at the time of our review was in an early stage of development,
is aimed at strengthening the supervision and regulation of
commercial banks in developing countries.  This effort, if
successful, would help those countries overcome weak commercial
banking systems, which is a major obstacle they can face in adopting
and maintaining policies that attract investors.  However, the
initiative may take much time for a variety of reasons, including
reported entrenched domestic opposition in some developing countries. 
A third G-7 initiative is aimed at improving IMF's surveillance of
member countries' economic and financial situations and policies. 
This initiative may also face a number of obstacles, most notably
IMF's lack of leverage over countries that are not receiving IMF
funds. 


   IMF'S VOLUNTARY DATA STANDARDS
   MIGHT HELP IMPROVE COUNTRY
   DATA, BUT IMF CANNOT ENSURE
   COMPLIANCE
---------------------------------------------------------- Chapter 3:1

One factor that has been cited as contributing to Mexico's 1994-95
financial crisis was Mexico's inadequate public disclosure of key
economic and financial data.  In 1995, IMF officials began
considering what role IMF might play in improving countries'
provision of such data.  IMF's ability to encourage better data
disclosure by countries was limited because, according to IMF, it had
no authority under its charter to require member countries to publish
economic or financial data.  Nevertheless, IMF's Executive Board
decided in April 1995 that it was appropriate and consistent with
IMF's articles of agreement for IMF to establish two voluntary
standards that IMF member countries could use when disclosing key
economic and financial data to markets.  IMF's intent was that the
use of these standards would encourage dissemination of
comprehensive, timely, accessible, and reliable economic and
financial statistics from countries to financial markets. 

One standard is to be called the General Data Dissemination Standard
and is intended for use by countries that are not yet active in
global capital markets--the majority of developing countries.  IMF is
in the process of developing this standard and hopes to have approval
from the Executive Board by fall 1997, according to an IMF official. 

The second standard, called the Special Data Dissemination Standard,
is stricter than the General Standard and is intended for use by
countries that are, or aspire to be, active in world financial
markets.  IMF began allowing countries to subscribe to the Special
Standard in April 1996, with a transition period that is to end on
December 31, 1998.  During the transition period, a country may
subscribe to the standard even if its data dissemination practices
are not fully in compliance with the Special Standard.  This
transition period is intended to give subscribing countries time to
adjust their practices to comply with the Special Standard.  As of
May 21, 1997, 42 countries had subscribed to the Special Standard,
including all of the G-10 countries and a number of developing
countries, such as Argentina, Malaysia, Mexico, the Philippines, and
Thailand. 

The Special Standard has (and the less strict General Standard is to
have, when it is completed) four dimensions:  (1) public access to
the data; (2) integrity of the data; (3) quality of the data; and (4)
the actual data, in terms of their coverage, frequency, and
timeliness.  The requirements for both standards are to be identical
for the first three of these dimensions.  The Special Standard
prescribes--and the General Standard is to prescribe--ready and equal
public access to country data through advance public notice of
release calendars and simultaneous release of data to all interested
parties.  For the integrity dimension, both standards are to require
(1) countries to identify the terms and conditions under which
official statistics are produced, (2) internal government access to
the data before release, and (3) ministerial commentary on the
occasion of statistical release.  Integrity is to be further ensured
by a requirement that countries disclose information about revisions
to their data and give advance notice of major changes in
methodology.  For the quality dimension, countries are to disseminate
documentation on methodology and sources used for their statistics,
component details of the data, reconciliations with related data, and
statistical frameworks that support statistical cross-checks and
provide assurance of reasonableness. 

For the data dimension, the Special Standard lists 17 categories of
mandatory data that cover the four sectors of a country's economy: 
the real, fiscal, financial, and external sectors.\1 For each data
category, the Special Standard specifies how often the country is to
report the data and how timely the reporting must be (the permitted
lag).  For example, one type of data that must be reported for the
external sector is a country's international currency reserve levels. 
The Special Standard specifies that a country must report its gross
official international currency reserves, denominated in U.S. 
dollars, on a monthly basis with no more than a 1-week lag.  Appendix
II of this report shows all of the Special Standard's 17 data
categories and their reporting requirements.  These reporting
requirements are more rigorous than those planned for the General
Standard. 

IMF does not plan to publish the country data.  Instead, IMF has
established a data dissemination electronic bulletin board on the
Internet that displays information about the IMF data standards and
individual countries' data, and that explains how interested parties
may obtain the data.\2 For 7 of the 42 subscribing countries, the
descriptions of the data on IMF's bulletin board are linked
electronically to the data themselves, which are maintained by the
country.  IMF plans eventually to link its electronic bulletin board
to all subscribing countries' data. 

Capital market participants and other experts with whom we spoke
generally praised IMF's efforts to create standards for countries'
provision of data to the public.  An official from an association of
commercial and investment banks and other financial institutions told
us that he believed IMF's standards will improve the flow of key
information to financial markets.  IMF's data dissemination standards
appear to be a market-based effort to address a specific problem in
capital markets that can interfere with markets' ability to
anticipate and avoid sovereign financial crises. 


--------------------
\1 The IMF Special Standard encourages, but does not require, that
data be reported in two other categories:  population and
forward-looking indicators, such as qualitative business surveys. 

\2 The bulletin board's Internet address is http://dsbb.imf.org. 


      IMF IS TO RELY ON FINANCIAL
      MARKETS TO MONITOR AND
      ENFORCE ADHERENCE TO THE
      DATA STANDARDS
-------------------------------------------------------- Chapter 3:1.1

IMF publications state that IMF expects countries that subscribe to
the standards to comply with them.  Furthermore, IMF's data
dissemination standards electronic bulletin board informs users that,
after the Special Standard's transition period ends at the end of
1998, IMF will remove countries from the list of subscribing nations
if IMF finds serious and persistent noncompliance.\3

However, citing both resource constraints and a lack of authority to
require member countries to publish data, an IMF official said that
IMF does not plan to (1) verify the data that countries publish under
the data dissemination standards or be responsible for the data's
accuracy or (2) regularly monitor countries' compliance with the data
standards.  Instead, IMF plans to rely on financial market
participants to monitor countries' compliance with the data
standards.  According to the IMF official, when market participants
have concerns about countries' compliance, IMF will expect them first
to bring their concerns to the attention of the authorities of the
country in question.  However, IMF officials do plan to monitor the
data to some extent because IMF staff plan to use the data that the
countries publish for a variety of purposes and, in doing so, may
detect discrepancies.  Also, IMF officials said that IMF will devote
some attention to observance of the data dissemination standards as a
part of its official surveillance of member countries' economic and
financial policies and also during its annual Article IV country
consultations. 

Furthermore, IMF officials have stated that IMF will rely primarily
on capital market participants to enforce compliance with its data
standards.  This enforcement is to occur through the process of
market discipline, whereby market participants would remove or
threaten to remove funds from a country if they suspect it is not
providing accurate, timely data to markets and, thus, would induce
the country to comply. 


--------------------
\3 At the time of our review, IMF had not determined the process by
which IMF would decide to disqualify a member country from the
Special Standard.  IMF plans to determine this process by the end of
the transition period. 


      FINANCIAL MARKET
      PARTICIPANTS MAY NOT HELP
      MONITOR STANDARDS
-------------------------------------------------------- Chapter 3:1.2

Market discipline exercised by capital market participants may help
enforce adherence to IMF's data dissemination standards to some
extent.  In some cases, individual investors may become suspicious of
a country's data quality, and remove some or all of their funds from
the country.  This act might discipline the country to improve its
data by signaling other market participants to question the data and
remove their funds from the country, as well.  However, the ability
of market discipline to anticipate and avoid sovereign financial
crises has varied in the past, as Mexico's 1994-95 financial crisis
demonstrated. 

Furthermore, we were told that financial market participants will not
be able to monitor, or be willing to help IMF enforce, IMF's data
standards to the extent that IMF hopes.  Financial market
participants can be expected sometimes to inform IMF when they have
compliance concerns, especially in cases where the market
participants have raised their concerns with officials from the
country in question and have not received a satisfactory response. 
Increased contacts between IMF officials and capital market
participants could facilitate IMF's learning about these events. 
However, many financial market participants with whom we spoke said
(1) that market participants, for the most part, do not intend to
monitor countries' compliance with IMF's data standards and (2) that
they generally do not expect to keep IMF informed of any compliance
concerns they may have.  Moreover, to the extent that individual
capital market participants perceive that knowing a country's
published data are inaccurate might give them a competitive advantage
over other market participants, the participants may have a
disincentive to inform IMF of their compliance concerns. 

Moreover, IMF does not have a system in place to collect and assess
market participants' concerns over countries' compliance with the
Special Standard.  IMF's data dissemination standards Internet site
encourages users to comment on the standards initiative, but the site
does not solicit users' concerns about countries' compliance with the
standards. 


   INITIATIVES TO IMPROVE
   FINANCIAL STABILITY IN EMERGING
   MARKET COUNTRIES MAY NOT
   ACHIEVE TIMELY RESULTS
---------------------------------------------------------- Chapter 3:2

Following Mexico's crisis of 1994-95, a G-10 Working Party concluded
that the financial systems in emerging market economies--especially
the banking sector--should be strengthened to reduce the risk they
might pose in the event of a sovereign liquidity crisis.  More
attention needs to be paid to incipient problems in the banking
sector, the G-10 said.  According to a Treasury official, strong bank
supervisory regimes are essential to avoiding sovereign financial
crises.  This official said that emerging market banking systems need
to have ownership distributed widely, to be free from credit control
and credit allocation guidelines, and to be open to foreign banks. 
He said the best approach is to address underlying weaknesses by
ensuring a sound incentive and ownership structure, developing human
resources, requiring banks to hold adequate risk-weighted capital,
maintaining good accounting standards, and establishing an effective
system of bank supervision. 

In response to an initiative at the Lyon, France, summit in June
1996, representatives of the G-10 countries and of some emerging
market economies have sought to develop a strategy for fostering
financial stability in countries experiencing rapid economic growth
and undergoing substantial changes in their financial system.\4 A
G-10 document that lays out the Working Party's strategy\5 states
that countries have incentives to work toward robust financial
systems because such a system increases access to global financial
markets and provides benefits in the form of more stable and often
faster economic growth.  The document points out that the ultimate
responsibility for policies to strengthen financial systems lies with
national governments and financial authorities in the countries
concerned and that the role of the international community is to
provide advice, incentives, and a yardstick against which progress
can be measured.  The document acknowledges that the discussion is
general in nature and that specific priorities and time frames in any
given country or group of countries will often differ.  The document
also states that legal and judicial reforms will take longer to
achieve than revising capital adequacy requirements.  The four
components of the strategy are: 

  -- the development of an international consensus by G-10 and
     emerging market country representatives on the key elements of a
     sound financial and regulatory system;

  -- the formulation of norms, principles, and practices by
     international groupings of national authorities;

  -- the use of market discipline and market access channels to
     provide incentives for adoption of sound supervisory systems,
     better corporate governance, and other key elements of a robust
     financial system; and

  -- the promotion by multilateral institutions, such as IMF, the
     World Bank, and regional development banks, of the adoption and
     implementation of sound principles and practices. 


--------------------
\4 Representatives of Argentina, France, Germany, Hong Kong,
Indonesia, Japan, Korea, Mexico, the Netherlands, Poland, Singapore,
Sweden, Thailand, the United Kingdom, and the United States
participated in developing this strategy. 

\5 Financial Stability in Emerging Market Countries:  A Strategy for
the Formulation, Adoption and Implementation of Sound Principles and
Practices to Strengthen Financial Systems, Group of Ten (Apr.  1997). 


      OBSTACLES EXIST TO IMPROVING
      EMERGING MARKET BANKING
      SUPERVISION
-------------------------------------------------------- Chapter 3:2.1

A recent G-10 report found that progress in upgrading banking
supervision has not yet been widespread or substantial enough for the
banking system to serve as an ally to financial stability and
sustainable economic growth in emerging market countries.  Critics of
supervision improvement efforts have contended that international
organizations lack knowledge of emerging market banking systems and
have no powers to enforce bank regulatory standards.  According to
these critics, because entrenched opposition domestically and
considerations of competitiveness with other banks and countries
prevent bank supervisors in developing countries from acting
unilaterally, an international standard for emerging market bank
supervision and regulation developed by the Basle Committee for Bank
Supervision offers the best hope for improvements.  However, many
years were required for completion of the Basle Committee's effort to
create and gain adherence for capital adequacy standards to mitigate
banks' exposure to market risks.  Current initiatives to improve bank
supervision in emerging markets may also require considerable time. 


   IMPROVING IMF SURVEILLANCE OF
   KEY EMERGING MARKET COUNTRIES
   MAY FACE OBSTACLES
---------------------------------------------------------- Chapter 3:3

At the June 1995 summit held in Halifax, Nova Scotia, the G-7
governments recommended that IMF improve its surveillance.  A
background document prepared for the Halifax summit recommended that
IMF: 

  -- devote greater resources and attention to those countries of
     global significance, including both industrial and emerging
     market countries;

  -- devote more attention, in general, to financial and banking
     sector developments and, in particular, to the pattern of
     capital flows and their maturity;

  -- offer clear and direct policy advice to all governments,
     especially those that appear to be avoiding necessary policy
     measures (where IMF's country surveillance is ineffective, IMF's
     managing director and/or the representatives to IMF from the
     country in question should pass a strong message to the
     country's officials); and

  -- where feasible, be more open and transparent in its assessments
     and policy advice. 

To carry out these recommendations, IMF is pursuing a number of
changes to its surveillance policies and procedures.  According to an
IMF official, these improvements involve changes to the focus of IMF
surveillance, the continuity of this surveillance, the information
IMF requires member countries to disclose to IMF, and IMF's
"culture." IMF plans to refocus its surveillance to emphasize
countries whose economic problems could have a systemic impact on the
world's financial system.\6 To this end, IMF has created within its
research department a new division that focuses on capital flows and
on fast-growing emerging market countries.  IMF staff are to pay
greater attention to countries' capital accounts--especially their
debt structures and financing policies and the risks of overreliance
on easily reversible capital flows--and the soundness of their
financial sectors.  To help in this, IMF analysts are to make greater
use of data generated by financial markets. 

Regarding continuity in surveillance, IMF is trying to increase the
frequency and timeliness of its surveillance.  An IMF official told
us that the proportion of member countries that have an Article IV
consultation every 15 months rose from 71 percent in 1993 to 77
percent in 1996.  Several IMF officials also said that surveillance
between Article IV consultations has been enhanced.  They said that
informal IMF staff visits to countries occur more frequently now,
especially to countries that are not receiving funds from IMF, and
that IMF now tries to send missions to countries as problems develop,
rather than waiting for the next annual Article IV cycle.  Also, an
IMF official told us that there are now more frequent IMF Executive
Board meetings to review situations in particular countries.  At
monthly meetings, on a rotating basis, IMF department directors brief
board members on situations in the countries under their
jurisdiction.  A department director now can request a special
meeting of the Executive Board to discuss a country, as well. 
Finally, an IMF official told us that every 6 months staff in IMF's
Policy Development and Review office prepare a report for the
Executive Board's consideration that assesses the extent to which
selected member countries have implemented some of IMF's policy
recommendations.  These reports, which have included reviews of some
emerging market countries, allow the Executive Board an opportunity
to review situations in nonprogram countries in addition to those
countries' annual Article IV consultations, the IMF official said. 

In addition, IMF has revised its policies on the data that countries
are required to provide IMF for surveillance purposes.  In its
post-Mexico crisis review of surveillance, IMF found that, although
data provision to IMF was adequate for the majority of member
countries, deficiencies existed for many members.  In September 1995,
IMF's Executive Board agreed to a set of 12 core data categories,
representing "the absolute minimum" set of categories to be provided
by all members to IMF on a regular and timely basis for continuous
surveillance.\7 The categories include exchange rates, international
currency reserves, the external current account balance, and external
debt and debt service.\8 IMF is in the process of defining the
appropriate coverage, periodicity, and timeliness for these data. 
However, IMF anticipates that it will require that as many of the
data categories as possible be reported monthly, especially those
relevant for monetary policy, and that at times of exchange market
tension, certain types of data, such as foreign exchange reserves and
foreign debt, might have to be reported more frequently. 
Furthermore, IMF anticipates that, for many countries, the list of 12
data categories will need to be supplemented with other required
data.  In September 1995, IMF's Executive Board decided that all
member countries should at least maintain their current levels of
reporting of data to IMF.  According to an IMF official, all Article
IV staff appraisals now are to have a section on data quality and
timeliness.  This official also said that Article IV reviews will be
used as a "consciousness-raising exercise" to encourage better
transmission of data by countries receiving IMF funds, both to IMF
and to financial markets. 

An IMF official told us that IMF will be less tolerant of countries
in an IMF program when these countries allow their data quality or
timeliness to deteriorate.  To enforce this, IMF plans to use a
graduated approach.  When members are reluctant to provide data that
would allow effective surveillance, IMF staff and management, with
assistance from the country's representative to IMF, are to discuss
the matter with the country's authorities.  If this does not resolve
the problem, the matter may be elevated to IMF's Executive Board. 
Where insufficient data provision is caused by weak statistical
infrastructures, IMF staff are to work with the country's officials
to improve data systems and offer technical assistance, where
desirable. 

IMF also has attempted to change IMF's culture.  According to both an
IMF document and an IMF official, a 1995 internal IMF study
reportedly found that IMF's culture tended to encourage close
relationships between IMF staff and country authorities, and that IMF
staff tended to give country authorities the benefit of the doubt
when they had concerns over the country's policies.  An IMF official
told us that IMF staff are now more candid with country authorities,
especially during Article IV consultations, and that IMF staff are
less likely than before Mexico's recent crisis to give country
authorities the benefit of the doubt. 


--------------------
\6 An IMF official told us that IMF has not created, nor does it plan
to create, a "watchlist" that identifies which countries would
threaten global financial stability if they encountered a financial
crisis.  According to the official, IMF's Executive Board was
concerned about the consequences if financial markets were to learn
which countries were on such a list and that the existence of such a
list might cause IMF to focus unduly on those countries even when
situations change. 

\7 The requirements of the 12 data categories are different from, and
less strict than, the requirements of IMF's Special Standard for
publicly disclosing data.  The reason for this is that all countries
are required to furnish these data to IMF, whereas the Special
Standard is designed for countries that are active in global capital
markets and, therefore, could be made more demanding. 

\8 The other categories are:  central bank balance sheet, reserve or
base money, broad money, interest rates, consumer price index,
external trade (i.e., exports/imports), fiscal balance, and gross
national product or gross domestic product. 


      SOME FACTORS MAY LIMIT IMF'S
      EFFORTS TO HELP AVOID FUTURE
      SOVEREIGN FINANCIAL CRISES
-------------------------------------------------------- Chapter 3:3.1

It appears that the steps IMF has taken to improve its country
monitoring represent a conscientious effort to address weaknesses in
surveillance and could improve the quality of IMF's surveillance.  If
successful, these initiatives might contribute to the avoidance of
future sovereign financial crises.  However, IMF's improved
surveillance and related advisory services may be subject to some
limiting factors already familiar to IMF.  Notably, it is likely that
IMF will continue to have only limited influence over countries that
are not in an IMF program.  This may be especially true for
nonprogram countries that are receiving large private capital
inflows.  Such countries, as Mexico was in 1994, would not likely
anticipate having to borrow funds from IMF and might conclude that
financial markets will continue to lend them funds.  Therefore, such
countries could resist adopting policy changes recommended by IMF. 
Another factor is that some sovereign financial crises are the result
of a complex interaction of economic, financial, political, and other
factors that are difficult for anyone to anticipate.  And, IMF's
surveillance is likely to continue to be limited by the quality of
IMF's analyses of countries' situations and policies, which in the
past has varied. 


MOST RESOLUTION IMPROVEMENT
APPROACHES MIGHT REDUCE U.S. 
BURDEN, BUT MANY MAY NOT HELP STEM
CONTAGION
============================================================ Chapter 4

At the time of our review, the G-7 and a G-10 Working Party had
proposed three IMF initiatives to improve existing mechanisms to help
resolve sovereign financial crises, and a number of proposals to
create new mechanisms had emerged.  Our analysis indicated that, if
these initiatives are implemented, they might reduce the U.S.  burden
in resolving crises compared to the 51-percent share of the
multilateral financial assistance provided to Mexico in 1995. 
However, the use of the initiatives could involve some trade-offs for
the United States. 

The G-7 initiatives were to:  (1) expand the General Arrangements to
Borrow (GAB) lines of credit to give IMF access to more funds should
they be needed to resolve a crisis that threatens the international
financial system and (2) create a new, expedited decisionmaking
procedure at IMF, called the Emergency Financing Mechanism, for use
in extraordinary circumstances.  The G-10 Working Party proposal is
to change IMF's policy to permit IMF to extend financing in
extraordinary circumstances to an indebted country before the country
has settled claims with its nonbank private creditors, as a way to
encourage such settlements (such extension of financing is known as
"lending into arrears").  During the time of our review, these
initiatives were in various stages of development. 

The proposed expanded GAB, which is to be called the New Arrangements
to Borrow (NAB), could reduce the U.S.  share of crisis resolution
funding compared to the proportion the United States contributed to
the 1995 assistance to Mexico.  However, because the United States
would contribute a smaller share of NAB's resources than under GAB,
U.S.  influence in NAB might be diminished because its voting power
also will decrease.  This reduced influence might make it harder for
the United States to obtain activation of NAB in cases where the
United States believed activation was desirable.  Similarly, the
increase in the number of countries that would participate in
decisions to activate NAB might not facilitate consensus
decisionmaking required for the use of the funds to stem contagion. 
On the other hand, because activation of NAB would require the votes
of countries holding a larger percentage of resources than under GAB,
the United States would more easily be able to block activation of
the new lines of credit.  Also, although use of an expanded GAB could
help minimize contagion effects in a sovereign financial crisis,
having NAB could increase moral hazard for debtor countries and
investors.  IMF's expedited decisionmaking procedures might speed IMF
assistance to prevent contagion in a crisis and reduce pressure on
the United States to act quickly unilaterally. 

An IMF lending into arrears policy for nonbank private debts might
speed resolution of some crises and perhaps help reduce IMF funding
for crisis resolution.  However, this policy change could harm
creditor interests in future sovereign financial crises and raise the
price of international capital to developing countries. 

Various improvement proposals suggested ways to encourage capital
markets to create mechanisms to apply principles of U.S.  bankruptcy
law to international sovereign default, including a proposal for the
development of an international bankruptcy court for countries. 
Although these proposals might eliminate or reduce public sector
financing costs and simplify some crisis resolution procedures, they
may be difficult to implement or may operate too slowly to limit
contagion. 


   INITIATIVES ARE UNDER WAY TO
   IMPROVE THE PROVISION OF
   OFFICIAL FINANCIAL ASSISTANCE
---------------------------------------------------------- Chapter 4:1

In May 1995, leaders of the G-7 countries recommended two initiatives
to improve the way the official sector can provide financial
assistance to countries that experience financial difficulties.  The
initiatives were to:  (1) create the NAB credit lines to give IMF
access to more funds should they be needed to resolve a crisis that
threatens the international financial system and (2) create the
Emergency Financing Mechanism for use in extraordinary circumstances. 
In May 1996,\1 a G-10 Working Party proposed a change in IMF's policy
to permit IMF to extend financing in extraordinary circumstances to
an indebted country before the country has settled claims with its
nonbank private creditors, as a way to encourage such settlements. 
IMF has implemented the emergency financing mechanism.  The creation
of NAB awaits approval from the participating governments.  At the
time of our review, IMF was in the process of determining whether to
change its lending into arrears policy. 


--------------------
\1 The Resolution of Sovereign Liquidity Crises, Group of Ten (May
1996). 


      SUPPLEMENTING GAB WITH NAB
      WOULD REDUCE THE RELATIVE
      U.S.  SHARE OF IMF FUNDING
      TO RESOLVE CRISES, BUT WOULD
      INVOLVE TRADE-OFFS
-------------------------------------------------------- Chapter 4:1.1

One initiative by the G-7 is to increase official resources available
to IMF for responding to financial emergencies or impairments of, or
threats to, the international monetary system.  For 35 years, IMF has
had GAB to help ensure that IMF is able to meet urgent and
potentially large demands on its resources.\2 GAB is a borrowing
arrangement\3 between IMF and a group of 11 industrialized countries
or their central banks that allows IMF to (1) borrow currencies from
these countries under specific conditions and (2) lend the funds
either to other GAB countries or to non-GAB IMF member countries.\4
The 11 participants of GAB are:  Belgium, Canada, France, Deutsche
Bundesbank (German Central Bank), Japan, Italy, the Netherlands,
Switzerland (Swiss National Bank), Sveriges Riksbank (Swedish Central
Bank), the United Kingdom, and the United States.\5 A country
receiving funds from IMF under GAB is charged a market interest rate
and pays interest quarterly.  A country is required to repay the
amount of the loan within 5 years. 

GAB funds are meant to supplement ordinary IMF resources, which
amounted in 1996 to $203 billion.\6 The total of GAB resources are
$23.8 billion, with an additional $2.1 billion available under a
separate agreement with Saudi Arabia.\7 Under GAB, the U.S.  share is
about $6.0 billion, or 25 percent, of GAB; the German Central Bank
share is about $3.3 billion, or 14 percent, of GAB; Japan's share is
about $3.0 billion, or 12.5 percent, of GAB; and the share of France
and the United Kingdom is each $2.4 billion, or 10 percent each, of
GAB.  Other country and central bank shares are less.\8 These
contributions broadly reflect each country's size and role in the
international economy as well as the ability of each country to
provide financing.  See figure 4.1 for the credit commitments of
other countries and figure 4.2 for relative country shares. 

   Figure 4.1:  Participant Credit
   Commitments Under the General
   Arrangements to Borrow

   (See figure in printed
   edition.)

Source:  IMF. 

   Figure 4.2:  Participant Shares
   Under the General Arrangements
   to Borrow

   (See figure in printed
   edition.)

Source:  IMF. 


--------------------
\2 GAB was originally established in 1962 out of concern for the
adequacy of official resources of international liquidity and the
disruptive effects of short-term capital movements. 

\3 Treasury officials told us that both GAB and NAB are a set of
contingent lines of credit and not a single, comprehensive line of
credit. 

\4 GAB can be activated to supplement IMF resources to help finance
(1) conditional or unconditional drawings by countries participating
in GAB to forestall or cope with an impairment in the international
monetary system or (2) conditional drawings by nonparticipants when
an exceptional situation exists that could threaten the stability of
the international monetary system. 

\5 The German Central Bank, Swedish Central Bank, and Swiss National
Bank are empowered by domestic legislation to lend to IMF. 

\6 This dollar figure and GAB/NAB dollar values are converted from
Special Drawing Rights (SDR) at the rate of 1.4 SDR/dollar.  We took
the May 30, 1997, rate of 1.3918 SDR/dollar and rounded it up to 1.4
SDR/dollar.  SDR is a unit of account IMF uses to denominate all its
transactions.  Its value comprises a weighted average of the value of
five currencies, of which the U.S.  dollar has the largest share. 

\7 Saudi Arabia has an associated arrangement whereby it will lend to
IMF for the same purposes and in the same circumstances as prescribed
by GAB, except in three ways.  First, IMF is not authorized to call
on GAB to finance transactions with Saudi Arabia.  Second, Saudi
Arabia is free to accept or reject any proposal by the IMF Managing
Director.  Third, GAB and the arrangements with Saudi Arabia may be
activated separately. 

\8 Other GAB-participant contributions are:  Italy, 6.5 percent; the
Swiss National Bank, 6 percent; Canada, 5.25 percent; the
Netherlands, 5 percent; Belgium, 3.5 percent; and the Swedish Central
Bank, 2.25 percent. 


         CONDITIONS FOR ACTIVATING
         GAB
------------------------------------------------------ Chapter 4:1.1.1

GAB can be activated if IMF's Executive Board and GAB participants
representing three-fifths, or 60.0 percent, of the total of credit
arrangements and two-thirds, or 66.6 percent, of the participants
determine that the following two conditions are met:  (1) the
international monetary system is threatened and (2) IMF lacks
sufficient resources to extend the needed financing.  Individual GAB
participants can opt out of GAB participation if they are having
balance-of-payments problems.  A GAB participant may not vote on a
proposal to activate GAB to finance an IMF transaction with that
participant. 

No formal criteria exist for determining the existence of a threat to
the international monetary system.  IMF officials said that the
nature of threats to the international financial system changes as
that system evolves.  As illustrated by the controversy that arose
during Mexico's 1994-95 financial crisis, countries can disagree
about the existence or extent of a potential threat to the
international monetary system.  With its 25-percent share of GAB
resources, the United States can block GAB activation if it obtains
the support of other GAB participants that have credit commitments
large enough to reach 40 percent of the total resources. 

Over the course of the 35 years that GAB has existed, it has been
activated nine times to assist the United States, France, Italy, and
the United Kingdom.  An IMF official said that GAB was activated in
the 1960s and 1970s both to resist and assist devaluations of these
countries' currencies.  GAB was last activated in 1978, when the
United States drew more than $2.9 billion from its own reserve
tranche, including $994 million in funds from loans under GAB and
more than $1.9 billion from IMF currency holdings.\9 Since 1983, GAB
resources have been made available to assist countries that do not
participate in GAB, but such use has not occurred, nor has it been
proposed.  GAB is considered an insurance policy and is not intended
to be a regular source of financings, according to a U.S.  Treasury
official. 


--------------------
\9 These funds were part of a package to defend the dollar, which
also included funds from gold sales and special financial instruments
issued in foreign currencies.  The General Arrangements to Borrow,
Michael Ainley, IMF (Washington, D.C.:  1984). 


         NAB WOULD INCREASE
         OFFICIAL RESOURCES FOR
         IMF RESOLUTION OF
         FINANCIAL CRISES
------------------------------------------------------ Chapter 4:1.1.2

The G-7 proposed that the G-10 and other countries increase IMF
resources through the use of the proposed NAB.  NAB would increase
the resources available under the GAB credit lines to about $47.6
billion, up from the current GAB level of about $23.8 billion.  NAB
participants would include the 11 countries and central banks in GAB
plus the following 14 new participants:  6 new European participants,
6 new Pacific Rim participants, and 2 Middle Eastern countries.  (See
table 4.1.) The wider participation under NAB reflects the changing
character of the global economy and a broadened willingness to share
responsibility for managing the international monetary system. 



                                    Table 4.1
                     
                            Proposed NAB Participation

                 Geographic regions and participating countries
--------------------------------------------------------------------------------
Participation     Europe    Pacific Rim       North America     Middle East
----------------  --------  ----------------  ----------------  ----------------
Existing GAB      German    Japan             United States     None
participants      Central                     Canada
                  Bank
                  United
                  Kingdom
                  France
                  Italy
                  Belgium
                  Swedish
                  Central
                  Bank
                  Netherla
                  nds
                  Swiss
                  National
                  Bank

Additional        Austria   Australia         None              Kuwait
participants      Denmark   Hong Kong                           Saudi Arabia
joining NAB       Finland   Monetary
                  Luxembou  Authority\a
                  rg        Korea
                  Norway    Malaysia
                  Spain     Singapore
                            Thailand
--------------------------------------------------------------------------------
\a The Hong Kong Monetary Authority's participation in NAB is subject
to the consent of the member whose territories include Hong Kong. 
Hong Kong was a territory of the United Kingdom until June 30, 1997,
after which Hong Kong reverted to China. 

Source:  IMF. 

The anticipated amounts of credit commitments and relative shares for
each of the NAB participating countries are provided in figures 4.3
and 4.4.  The proposed amount for the United States is $9.4 billion,
which represents slightly less than 20.0 percent of the total NAB
resources.  The German Central Bank and Japan each are to contribute
about $5.0 billion, or 10.5 percent, of NAB.  France and the United
Kingdom are to each contribute $3.6 billion, or 7.6 percent, of the
total. 

   Figure 4.3:  Participant Credit
   Commitments Under the Proposed
   New Arrangements to Borrow

   (See figure in printed
   edition.)

Source:  IMF. 

   Figure 4.4:  Participant Shares
   Under the Proposed New
   Arrangements to Borrow

   (See figure in printed
   edition.)

Source:  IMF. 

NAB would not replace GAB, but it would be the facility of principal
resource--that is, a proposal for assistance would first be
considered under NAB; if rejected, the proposal could be made to GAB
participants.\10 The maximum amount of funds available under NAB
would be $47.6 billion.  One-half of this amount, or $23.8 billion,
would be available under GAB. 


--------------------
\10 Activation to finance an IMF transaction with a G-10 country is
an exception to this rule in that either GAB or NAB can be considered
first. 


         CONDITIONS FOR ACTIVATING
         NAB
------------------------------------------------------ Chapter 4:1.1.3

Under the NAB proposal, the following criteria used for NAB
activation would not change from the criteria used for GAB
activation:  IMF Executive Board and NAB participants must concur
with the IMF Managing Director's determination of an impairment in
the international monetary system and impaired IMF resources. 
However, activation of NAB is to require a larger majority voting
share than for GAB activation--80 percent of the total credit
arrangements, which is up from GAB's 60 percent.  The United States
can block activation if joined by any one other large participant or
two small participants.  Under the envisioned composition of NAB
participants, if one large or two small NAB participants do not vote,
then the United States can unilaterally block NAB activation,
according to Treasury officials.  Unlike GAB, NAB activation would
not require a second majority of two-thirds of the number of
participants voting. 

As with GAB, NAB resources could be used to assist either NAB
participants or nonparticipants.  Individual countries and
participating institutions would be able to opt out of NAB
participation if they were having balance-of-payments problems. 
Members that did not participate for this reason would lose their
"vote" in decisionmaking, and the voting share of the other
participating members would increase.  In addition to any meetings
needed for activation, NAB participants are to meet annually to
discuss macroeconomic and financial market developments that could
lead to requests for NAB activation.  NAB would enter into force when
adopted by participants with credit arrangements totaling about $40
billion, including the five participants with the largest credit
arrangements. 


         U.S.  PARTICIPATION IN
         NAB WOULD REQUIRE
         CONGRESSIONAL
         AUTHORIZATION AND AN
         APPROPRIATION
------------------------------------------------------ Chapter 4:1.1.4

Congressional approval would be necessary for the increased U.S. 
resources pledged to NAB.  According to established U.S.  budget
procedures, U.S.  participation in NAB would require congressional
authorization and appropriations.  Because $6.0 billion of the $9.4
billion needed to fund NAB have already been appropriated by Congress
to fund GAB, NAB funding requires an additional $3.4 billion in new
appropriations.  A transfer of dollars to IMF would not be scored as
a budgetary outlay because the United States receives in return for
the transfer a monetary asset (i.e., a liquid, interest-bearing claim
on IMF that is backed by IMF's financial position, including its
holdings of gold).  A senior Treasury official told us that U.S. 
participation in NAB would not affect the size of the U.S.  budget
deficit.  That is, an exchange of monetary assets is not scored as a
budgetary outlay, and therefore, does not have an impact on the
budget deficit. 


         OUR ANALYSIS OF NAB
------------------------------------------------------ Chapter 4:1.1.5

In our analysis of the proposal to establish NAB, we found two
significant trade-offs.  First, NAB could ease the relative U.S. 
burden of crisis resolution funding through increased burden sharing
among a greater number of countries when IMF resources are impaired
and the international monetary system is at risk.  Although the
dollar amount of the U.S.  share in NAB would increase, the U.S. 
share of the funding burden would be lower under NAB than under
GAB--about 20 percent compared with 25 percent.  Also under NAB, the
proportional U.S.  burden would be significantly less than the
51-percent share that the United States contributed to the 1995
multilateral financial assistance package for Mexico.  However, at
the same time, the larger number of NAB participants could dilute the
influence of the United States by decreasing its voting power.  The
reduced U.S.  voting share in NAB might make it more difficult for
the United States to convince others to activate NAB. 

Similarly, the larger number of countries in NAB could complicate
activation, since more countries will likely have to consent to
activate NAB.  Reaching a consensus among a sufficient number of
countries about whether the financial difficulties of one or more
countries pose a threat to the international monetary system might be
difficult, especially given the greater diversity of NAB membership
compared to GAB membership.\11 No specific formal criteria exist for
determining a threat to the international financial system. 
Uncertainty about the circumstances under which NAB will be used
helps diminish moral hazard on the part of countries and investors. 
As in the past under GAB, NAB participants may be more likely to view
a financial crisis in their geographic proximity as a threat to the
international monetary system than a financially troubled country
that is geographically, economically, or strategically distant from
the member country.  IMF and Treasury officials told us that NAB
participants who view the world regionally are shortsighted because
countries that expect help from outside their region now must be
willing to assist countries in other regions later.  To the extent
that NAB can be activated by its participants, the United States
might be less likely to be called on unilaterally to provide
financial assistance to countries in financial trouble.  To the
extent that NAB is difficult to activate, the United States may
continue to face the difficult choice of whether to act unilaterally
to assist financially troubled countries. 

Treasury officials told us that another one of NAB's new voting rules
could help compensate for the reduced U.S.  voting power in NAB. 
Under NAB, the GAB requirement that two-thirds of member countries
concur in activation is to be eliminated.  According to Treasury
officials, the dropping of this requirement would offset to some
extent the increased difficulty in activating NAB that would be
caused by the increase in the share of contributions needed for
activation from 60 percent under GAB to 80 percent under NAB. 

Second, NAB could help minimize contagion effects of a sovereign
financial crisis because investors may have more confidence that the
official sector will have sufficient funds to prevent a specific
country's financial difficulties from impairing the international
monetary system.  However, NAB could increase moral hazard for debtor
countries and investors.  For example, NAB could increase moral
hazard by providing an incentive for financial officials in debtor
countries to develop ill-advised financial, monetary, and
exchange-rate policies because NAB resources would be available to
bail them out if their policies failed.  Other critics have
maintained that moral hazard for investors would be increased if NAB
resources were used to shield investors in emerging market countries
from any financial losses. 

Treasury officials told us that moral hazard cannot be entirely
eliminated but that it can be held to acceptable levels if official
involvement in dealing with sovereign financial crises is rare and
limited to exceptional circumstances.  In the case of standing
financial arrangements, such as GAB and NAB or IMF itself, moral
hazard is limited through the imposition of features such as policy
conditions and phasing of disbursements, according to the Treasury
officials. 

Others have said that the structure of NAB would not create or
increase incentives for debtor countries and investors to make
imprudent decisions because there is no certainty that NAB would be
activated for any particular country or set of circumstances. 
Treasury officials told us that the G-7 was careful to design NAB
with built-in redundant mechanisms to minimize moral hazard, notably,
criteria that NAB shall only be used in cases of a threat to the
international monetary system and the larger, 80 percent, majority
required to activate NAB.  In fact, with an 80-percent voting share
required for activation, the United States would more easily be able
to block activation of the new credit lines despite having a smaller
voting share than under GAB.  Under NAB, the United States and any
other large NAB participant or two small NAB participants would have
sufficient votes to block the credit lines' use, according to
Treasury officials.  Furthermore, NAB funding may not create or
increase moral hazard for countries because IMF imposes stringent
economic and financial conditions on countries, according to a U.S. 
Treasury official. 


--------------------
\11 Treasury officials said that GAB was not used in the 1994-95
Mexican crisis primarily because IMF had sufficient liquidity to
supply its share of the needed funds.  However, the officials also
said that some GAB participants believed that the Mexican crisis did
not pose a threat to the international financial system and,
therefore, did not meet the second GAB activation criterion. 


      EXPEDITED DECISIONMAKING
      COULD SPEED IMF ASSISTANCE
      TO LIMIT CONTAGION
-------------------------------------------------------- Chapter 4:1.2

With the speed at which capital flows can be reversed, debtor
countries can quickly find themselves considered poor credit risks
and excluded from international capital markets.  Under certain
circumstances, the official sector may need to act quickly to prevent
the collapse of a country's finances, forestall contagion, and help
minimize the time that the debtor country may be excluded from
capital markets.  The approval of IMF support, from the onset of
Mexico's crisis in 1994, took 6 weeks.  This experience underscored
the need for earlier IMF decisions.  Also, some G-10 members said
that they were not adequately consulted in the process of developing
IMF assistance. 

The G-7 recommended that IMF accelerate its decisionmaking process
about funding to countries experiencing a financial crisis.  The IMF
Executive Board agreed in September 1995 to establish exceptional
procedures in what the Board has called an emergency financing
mechanism.  The new procedures are limited to exceptional situations
that threaten member financial stability, with significant risks of
contagion, and require accelerated negotiations.  Such situations may
or may not include NAB activation.  According to an IMF document, it
is not the purpose of the emergency financing mechanism to provide
guarantees of any kind against sovereign default. 

After the Executive Board agrees that extraordinary circumstances are
at hand and activates the emergency financing procedures, the Board
is to review a report describing the member country's current
economic situation.  The Executive Board is to be regularly briefed
on negotiations with the country, and key creditors are to be
consulted.  Rapid negotiations and quick IMF decisionmaking is
critically dependant on the readiness of a country to take measures
to deal with the crisis.  A member's past cooperation with IMF is to
have a strong bearing on the speed with which IMF can assess the
situation.  When agreement between the borrowing country and IMF is
reached, agreement documents are to be circulated within 5 days and
the IMF Executive Board is to meet within 48 to 72 hours.  Members
who overcome their crises quickly are to repay IMF on an accelerated
basis. 


      OUR ANALYSIS OF EXPEDITED
      IMF DECISIONMAKING
-------------------------------------------------------- Chapter 4:1.3

The expedited IMF decisionmaking process could help provide a speedy
official response to stem contagion effects on financial markets in
other countries and, possibly, to forestall or mitigate international
systemic risk.  In some crisis situations, a speedier IMF
decisionmaking process could reduce pressure on the United States to
act quickly unilaterally.  To the extent that the new emergency
financing mechanism would speed official resources to debtor
countries in crisis, it would also be responsive to criticisms that
mechanisms for responding to country crises are too cumbersome and
slow.  However, although the emergency mechanism could speed funding
decisions, it is not likely to lessen disagreement among IMF
Executive Board members and those they consult about the
seriousness--i.e., the extent of potential contagion or systemic
risk--of any particular financial crisis the Board confronts.  To the
extent that IMF Executive Directors have difficulty reaching a
consensus on whether the extraordinary circumstances needed to use
the emergency financing mechanism are present, IMF assistance may not
be quick enough to stem contagion and minimize systemic risk.  IMF
Executive Directors have noted the lack of objective criteria for
advance identification of financial crises requiring rapid response,
according to an IMF document. 

The moral hazard effects of an expedited IMF decisionmaking process
are unclear, according to our analysis.  An expedited consultative
and decisionmaking process at IMF might heighten incentives for
debtor countries to seek official financing, if the possibility of a
more timely decision about whether or not a country would get
assistance makes such financing more desirable.  However, the
financial and economic conditions that necessitate IMF assistance, as
well as the conditions that follow from IMF assistance, are often
severe.  Countries often prefer not to devalue their currency, limit
credit, reduce budget outlays, and increase taxes, which are measures
that IMF often requires as a condition of assistance.  The existence
of an emergency financing mechanism would guarantee neither IMF
support nor unusual access to IMF funds, according to an IMF
document. 


      CHANGES IN LENDING POLICY
      COULD SPEED RESOLUTION, BUT
      MAY HARM CREDITOR INTERESTS
      AND RAISE THE COST OF
      CAPITAL
-------------------------------------------------------- Chapter 4:1.4

IMF officials told us that they are considering a G-10 recommendation
that IMF expand its existing policy of lending, in exceptional
circumstances, to countries that are behind on their payments of
principal and interest to noncommercial bank private creditors.  This
policy is called lending into arrears.  Such a policy is intended to
prevent a failure to reach an agreement with creditors from holding
up implementation of IMF assistance.  Since 1970, IMF policy has been
to provide assistance only after a country has reached an agreement
with private creditors on a timetable for eliminating arrears.  The
first exception to the no-arrears policy provided that arrears to
official creditors would not preclude disbursements under an IMF
program if a Paris Club agreement covering those arrears had been
reached.  The policy was revised in the late 1980s when there was a
problem of widespread arrears and IMF assistance was being delayed as
some small commercial banks sought to hold up debt restructuring
agreements with debtor countries, with the objective of being bought
out by other larger banks.  The policy was amended to provide that
arrears to private bank creditors would not preclude disbursements
under an IMF program if a critical mass of the arrears were the
subject of an agreement among the banks.  According to the G-10, a
policy of lending into arrears may provide IMF and the official
sector with an opportunity to manage a crisis by signaling confidence
in debtor country policies. 

As a general rule, current IMF procedures require clearance of
arrears or imminent clearance of arrears before IMF disbursement of
financial assistance.  In most cases, for arrears to commercial
banks, IMF will not disburse funds before actual or imminent
agreement on clearance of arrears.  For arrears to official
creditors, IMF typically waits for imminent agreement in the Paris
Club before assisting a debtor country.  However, IMF policy does
permit lending into arrears for debts owed to sovereign creditors and
commercial banks in exceptional circumstances.  Therefore, in
situations where a debtor country is late in payments on its
financial commitments, and there is neither imminent agreement nor
extraordinary circumstances, its access to IMF assistance is blocked. 
This can be a serious problem for countries who have no other source
of financing than IMF and whose economic situation is deteriorating. 
Lending into arrears can provide financing that can jump-start a
debtor country's economy in an environment where private creditors
are difficult to mobilize.  In some cases, member countries that
agree to follow a program monitored by IMF will receive help in
obtaining bank creditors and other loans to clear its arrears.  An
IMF official told us that clearance of arrears takes an average of 3
years, with a minimum of 6 months and a maximum of 7 years. 


         SHARING THE BURDEN OF
         COUNTRY REFINANCING
------------------------------------------------------ Chapter 4:1.4.1

IMF's prohibition against lending into arrears was developed as a
mechanism to ensure that all groups of creditors share the burden in
country refinancing, according to IMF documents.  IMF has only been
partially successful in achieving this goal because (1) not all
commercial banks have contributed commensurate with debtor country
needs and (2) the exposure of the bilateral and official sector has
grown substantially.  Creditor groups not willing to contribute
should not be able to accumulate claims that are ultimately paid out
of the resources other creditor groups are providing, the IMF
documents stated.  The abrupt termination of commercial bank loans
creates financing needs that the official sector may not be prepared
to fully meet, and that the official sector may not want to be seen
as bailing out banks. 

In May 1996, a G-10 Working Party recommended that IMF's Executive
Board consider extending IMF's lending into arrears policy to
noncommercial bank private debts, i.e, to permit such lending in
exceptional circumstances, as is the case for official debts and
commercial bank debts.  An IMF official said that the lack of a
negotiating venue or group for financial instruments not held by
commercial banks or the governments of countries complicates
negotiations to end arrears.  A G-10 Working Party wrote that
allowing IMF to lend into arrears could strengthen the bargaining
position of debtor countries and signal that debtor country
adjustment efforts are satisfactory to IMF and, thereby, warranting
support from creditors.  Without IMF lending into arrears, policy
pronouncements by debtor countries concerning monetary, fiscal, and
exchange rate policies may have little credibility with creditors. 


         OUR ANALYSIS OF LENDING
         INTO ARREARS
------------------------------------------------------ Chapter 4:1.4.2

Creditors strongly oppose IMF's extending its lending into arrears
policy to cover noncommercial bank private debts.  One association
that represents commercial banks, investment banks, and other
financial institutions has written that IMF lending into arrears is
an official sector approval for a breach of contract.  This is
because changes in IMF procedures that improve the bargaining
position of debtor countries may force investors to renegotiate debt
with diminished principal and interest payments.  According to the
association, this runs contrary to investor expectations and may
increase the riskiness of bond financing and bank loans to countries
and their central banks.  Furthermore, according to the association,
lending into arrears raises the risk of moral hazard on the part of
debtor country officials by letting them know that they may be able
to make principal and interest payments at rates lower than
originally agreed.  Therefore, extending the policy to noncommercial
bank private debts would increase the risks to investors in emerging
market countries and would likely reduce the supply and raise the
price of international capital flows to emerging economies. 
Therefore, according to the association's report, extending IMF's
lending into arrears policy to noncommercial bank private debts may
harm creditor interests in future sovereign financial crises. 

However, such a policy could have the advantage of strengthening
IMF's ability to more quickly contain and resolve sovereign financial
crises, which could diminish the potential for future crises to pose
a risk to the international financial system.  Furthermore, extending
IMF's lending into arrears policy in this manner could reduce moral
hazard for investors.  Such a policy might diminish investor
perceptions that in a future sovereign financial crisis, public
financial assistance would fully insulate them from financial losses. 

Private creditors have an incentive to demand full payment according
to the original terms and condition of their bond contracts and are
less concerned about the impact on the debtor country or impact on
the international financial system.  It is not certain that creditors
as a group would fare worse if they were pressured to settle
outstanding claims with a country.  If such a settlement were being
impeded by individual creditors' delaying negotiations or holding out
and blocking implementation of a completed settlement, then creditors
as a whole could get more of their money back or get their money back
more quickly were IMF to induce them to complete a settlement. 


   BANKRUPTCY-BASED PROPOSALS
   MIGHT REDUCE PUBLIC FINANCING
   COSTS, BUT THEY COULD OPERATE
   TOO SLOWLY TO LIMIT CONTAGION
---------------------------------------------------------- Chapter 4:2

Several proposals suggested ways to reduce the need for official
sector assistance to resolve future financial crises by requiring or
encouraging capital markets to create mechanisms to apply principles
of U.S.  bankruptcy law to international default situations.  For
instance, one proposal suggested that an international bankruptcy
court be developed.  Other proposals suggested ways to apply specific
bankruptcy principles, and we categorized these proposals into three
groups:  (1) giving IMF authority and responsibility to apply the
principles; (2) making statutory changes so that country officials
and creditors would abide by the principles; and (3) encouraging the
private sector to develop market mechanisms, such as bond covenants
and bond committees, to apply the principles. 

One objective in applying principles of U.S.  bankruptcy law to
sovereign default situations would be to resolve creditor claims
without the need for official sector financing.  Three principles of
U.S.  bankruptcy law that could be applied to sovereign default
situations are commonly referred to as the following:  (1) automatic
stay, (2) postpetition creditor preference, and (3) "cramdown."\12

These principles are briefly described as follows: 

  -- The automatic stay principle prohibits creditors from attempting
     to collect a debt or obligation that was incurred by the debtor
     within a certain time before the bankruptcy petition was filed. 
     One effect of this principle is to allow a company or
     municipality to suspend payment of its debt to creditors. 
     Generally, the stay remains in effect until the bankruptcy court
     lifts it or the case is closed.  The stay is a measure that is
     intended to protect the debtor from attempts by individual
     creditors to seize assets at the expense of all creditors. 

  -- The postpetition creditor preference principle allows for the
     extension of "administrative priority" to new loans (made after
     the bankruptcy proceeding has begun) so that the debtor can
     obtain working capital to remain in operation.  Such credit
     generally is a first-priority administrative expense to ensure
     repayment of new loans ahead of any prebankruptcy loans. 

  -- The cramdown principle provides a way to prevent a minority of
     creditors from blocking a settlement of claims.  Where a
     qualified majority of creditors accepts a plan for reorganizing
     or rescheduling debt, the bankruptcy court can approve the plan
     as long as it is fair and equitable with respect to dissenting
     creditors.  This mechanism provides a way to control dissident
     creditors who otherwise could prevent the reorganization of the
     debtor or adjustment of its debts. 

According to some public and private sector officials, the
application of these bankruptcy principles to international sovereign
debt might foster investor confidence and could result in more
orderly and efficient resolutions of future debt crises, without the
need for official sector financing.  For example, an automatic stay
could provide "breathing room" to enable debtors and creditors to
examine the circumstances of a crisis and determine a resolution
strategy without the need for public financial assistance or the
threat of multiple lawsuits and the fear of losing much return on
investments.  However, some public and private sector officials also
believed that an underlying problem in applying these principles is
that debtor nations and their creditors would have to subordinate
their interests to the process used to interpret and implement these
principles.  As suggested by several proposals, this could be
accomplished by either a judicial-type body or other neutral,
competent institution or by other arrangements, such as market-based,
contractual commitments.  Sovereign debtors and their creditors might
not be willing to do this. 


--------------------
\12 Chapter 9 of the U.S.  Bankruptcy Code, 11 U.S.C.  section 901,
et seq., protects municipalities against creditor panics by providing
a process for adjustment of the municipalities' debts without
interference by the bankruptcy court in the exercise of the
municipalities' governmental powers.  Chapter 11 of the Code provides
for the reorganization of the debtor (typically a business) as an
alternative to asset liquidation. 


      INTERNATIONAL BANKRUPTCY
      COURT PROPOSAL IS NOT FULLY
      DEVELOPED AND HAS RECEIVED
      MIXED APPRAISALS
-------------------------------------------------------- Chapter 4:2.1

One proposal suggested that an international bankruptcy court or
similar formal procedure be established to apply principles of U.S. 
bankruptcy law to sovereign financial crises.  Such a court or
procedure might help capital markets overcome the problems they
sometimes have resolving sovereign financial crises. 

Although some officials representing academia, nonprofit
organizations, and the private sector have studied several issues
surrounding this proposal, specific implementation details were
either not available at the time of our review or varied as to how to
set up such a court and what institution, if any, should oversee its
operations.  Furthermore, the bankruptcy court proposal did not break
out the operational costs and who should provide funding for these
costs. 

To determine how such a court might be developed or operated, we
interviewed public and private sector experts and officials and
reviewed numerous reports and studies on the issue.  Some officials
said that such a court could be modeled after the operations of
existing institutions, such as the International Court of Justice.\13

Our review of some of the International Court of Justice's operations
showed that it has experienced numerous problems and has been used
relatively rarely.  We found no clear consensus regarding which
institution should act as or oversee an international bankruptcy
court.  However, some officials suggested that IMF or the World Bank
could perform this function because of their universal memberships
and significant experience in the debt-restructuring process. 
However, other officials questioned whether these institutions are
the best candidates.  For example, one academic reported that IMF has
not kept pace with changes in the world financial system and did not
do a good job in leading the debt restructurings in the 1980s.  Also,
questions have been raised about whether these institutions have
adequate resources to take on this responsibility and whether they
could be impartial due to their alleged susceptibility to political
pressure from member countries.  Finally, officials noted that there
could be challenges associated with specific implementation
procedures or processes, such as how a court could consistently apply
requirements to debtors and diverse groups of nonbank creditors with
different attitudes toward risk and commercial and legal doctrines
for debt-rescheduling. 


--------------------
\13 The International Court of Justice was established in 1945 as the
principal judicial body of the United Nations to settle disputes
peacefully among member nations. 


      ALTHOUGH AN INTERNATIONAL
      BANKRUPTCY COURT MAY NOT
      POSE A MORAL HAZARD, IT ALSO
      MAY NOT LIMIT CONTAGION
      EFFECTS
-------------------------------------------------------- Chapter 4:2.2

Proponents of developing an international bankruptcy court believed
that such a court would not pose a substantial risk of moral hazard
on the part of the debtor country.  The G-10 reported that bankruptcy
procedures do not substantially increase moral hazard on the part of
the debtor country if they do not significantly alleviate the pain
for the debtor that is associated with insolvency.  Some private
sector officials we interviewed said that country officials would not
default on debt obligations merely because a court action might allow
them to suspend debt payments or obtain new working capital. 
However, some other officials said that there could be a potential
for moral hazard on the part of the debtor country due to the
difficulties of defining and measuring the insolvency of a sovereign
nation and distinguishing between sovereign governments that "cannot
pay" from those who "will not pay."

Even though moral hazard might not be increased, several public and
private sector officials believed that an international bankruptcy
court may not limit contagion effects or systemic risks in a timely
manner.  Although supporters of this proposal hold that a court could
improve coordination and communication among debtors and creditors
during a workout process and the potential for investor panics could
thus be reduced, the court might have difficulty responding to and
resolving sovereign financial crises in a timely manner. 
Disagreements between debtors and creditors could be inevitable
regarding the purpose, formulation, and interpretation of bankruptcy
standards and procedures.  Furthermore, debtor countries might use
the court as a delaying tactic, and creditors might sue within their
own countries' legal systems to override the judgments of the court. 
These issues, coupled with the likelihood that a court would not have
sufficient power to enforce a workout plan, could add even more time
to crisis resolution.  Timeliness could be further impaired should
the court get bogged down in adjudicating single-country debt crises
that pose only a small threat to the international financial system
at the expense of crises that pose a more substantial systemic risk. 


      AN INTERNATIONAL BANKRUPTCY
      COURT COULD REDUCE THE NEED
      FOR OFFICIAL SECTOR
      FINANCING, BUT COUNTRIES MAY
      NEVER USE THE COURT
-------------------------------------------------------- Chapter 4:2.3

Supporters of developing an international bankruptcy court, or a
similar formal procedure, point out that one principal advantage of
such a mechanism is that a bankruptcy court could ensure that capital
markets deal with sovereign default with little or no need for
official sector financing.  From this point of view, less official
funding would be needed to assist countries in default because
debtors and creditors would be bound to resolve their claims in
court.  Moreover, sovereign borrowers would have to rely on private
capital markets, and the court could help supervise administrative
priority to new loans to ensure that countries in financial distress
would be in a good position to obtain much-needed working capital. 

An international bankruptcy court might offer two other advantages. 
First, supporters have asserted that such a court could provide
structure and predictability for sovereign default workouts.  Several
academic experts in this field have written that capital markets are
not efficient in dealing with sovereign bankruptcies due to the many
complex and often competing creditor claims, and that a court could
help creditors and debtors reach agreements.  Second, some officials
believe that a bankruptcy court for countries could make the burdens
of settlements more equitable.  With the protection afforded by the
bankruptcy court or procedure, these officials have argued, creditors
could be made to share the burden of adjustment more fairly with
debtor countries. 

Although a formal bankruptcy court or procedure for countries might
yield several advantages to the United States, the G-10 governments
and officials from other organizations have rejected the idea.  A
G-10 Working Party on resolving sovereign liquidity crises concluded
in its report that such procedures do not in current circumstances or
in the foreseeable future provide a reasonable way of dealing with
such crises.  The report argued that there are numerous challenges
associated with a bankruptcy court's development, implementation, and
enforcement, and that bankruptcy principles should not necessarily be
applied to international default situations because there is a false
analogy between helping bankrupt companies and governments'
experiencing financial difficultly.  However, the report acknowledged
that international sovereign bankruptcy procedures may warrant
additional study by other interested parties. 

Also, critics of this proposal have questioned whether nations would
(1) be willing to give up their sovereignty and agree to an
international body of bankruptcy law or (2) surrender their financial
and economic interests to the judgment of an international bankruptcy
court.  According to various legal experts, the International Court
of Justice has had a problem with this issue because, among other
reasons, governments have preferred to keep all law-creating and
law-defining processes firmly within their control.  The experts
questioned whether a common international law could be developed due
to the many different sets of cultural and legal values that operate
globally.  As a result, the United Nations' member countries have
infrequently used the International Court of Justice--only about 40
disputes have been submitted to the Court during the last 47
years.\14

Critics also have argued that, even if countries were willing to give
up their sovereignty and use an international bankruptcy court, the
effectiveness of such a court could be limited unless it had the
inherent power to enforce its decisions.  Moreover, they pointed out
that a court might not ever be able to guide required policy changes
in government operations the way a national bankruptcy court guides
the reorganization plans of firms.  As a result, an international
bankruptcy court might only be able to serve as an advisory body,
which is the same problem that has been experienced by the
International Court of Justice. 


--------------------
\14 One well-known case that illustrates the reluctance of countries
to use the International Court of Justice occurred when the United
States withdrew from court proceedings in the case concerning
Military and Paramilitary Activities in and against Nicaragua in
January 1985.  In its withdrawal notice, the United States alleged
that "the Court lacked jurisdiction and competence."


      OTHER BANKRUPTCY-BASED
      PROPOSALS FACE
      IMPLEMENTATION CHALLENGES
-------------------------------------------------------- Chapter 4:2.4

Additional proposals to reduce the need for financial assistance from
the public sector pertained to applying specific U.S.  bankruptcy
principles to international sovereign default.  We categorized these
proposals into three groups:  (1) giving IMF authority and
responsibility to apply the principles, (2) making statutory changes
so that country officials and creditors would have to abide by the
principles, and (3) encouraging the private sector to develop market
mechanisms, such as certain bond covenants and a standing committee
to represent bondholders to apply the principles. 


         PROPOSAL GIVING IMF THE
         AUTHORITY TO APPLY
         SPECIFIC PRINCIPLES IS
         NOT BEING PURSUED
------------------------------------------------------ Chapter 4:2.4.1

Two proposals by international financial experts suggested ways to
give IMF the authority to apply specific bankruptcy principles.  One
proposal was for IMF to reinterpret its mandate to allow it to
sanction and enforce countries' suspension of debt payments to
creditors.  This proposal, in essence, would apply the automatic stay
principle of the U.S.  Bankruptcy Code.  IMF Article VIII(2)(b)
provides that IMF has some authority over exchange contracts that
involve the currency of any of its members.  Under this article,
exchange contracts that (1) involve the currency of a member and are
contrary to exchange control regulations of that member and (2) are
maintained or imposed consistently with the IMF Articles of Agreement
are unenforceable in the territory of members.  Supporters of this
proposal have argued that IMF could interpret this provision in such
a way as to formally endorse the existence of a member's arrears. 
According to this view, IMF could use its authority under the article
to render exchange contracts unenforceable, and, in effect, sanction
a standstill, thus protecting a country from its creditors.  However,
critics question whether IMF can legally interpret the article to
give it authority to sanction a standstill.  Another proposal
suggested that IMF develop a mediation service to apply the cramdown
principle to help debtors and creditors renegotiate debt settlements. 

Both of these proposals are at an early stage of development so they
lacked sufficient information for detailed evaluation.  Furthermore,
IMF officials told us that they were not pursuing these proposals as
viable options.  Although the proposals suggest interesting possible
ways to help resolve future crises, they might be difficult to
develop.  There are two primary potential benefits to the first
proposal.  IMF (1) might be in a good position to sanction an
automatic stay because it has authority and expertise to evaluate a
country's policies and financial needs and to judge whether a stay is
justified and (2) would have more control over contagion effects
because it could actively signal to financial markets that a
country's temporary debt payment suspension is appropriate, which, in
turn, could assure markets that the country will pursue sound
policies in the future.  Therefore, the country would not lose access
to new capital in the future.  However, critics question the legal
acceptability of IMF's reinterpreting its Articles of Agreement to
give it authority to suspend country debt payments.  Several academic
experts reported that the articles would probably have to be amended
and that doing so could be a difficult, time-consuming task.  These
experts also noted that approval would be required from one-half of
IMF's member countries with most of the total voting power, and that
most member countries probably would resist the amendment on behalf
of the rights of their investors. 

Regarding the second proposal, IMF might be able to offer mediation
services similar to those offered by the World Bank's International
Center for the Settlement of Investment Disputes.\15 An IMF official
said that this is not a viable option because there are many
mediation services available and that mediation services are not part
of IMF's mission.  Also, critics of this proposal have raised
questions as to whether IMF could be neutral serving in a mediation
capacity. 


--------------------
\15 The International Center for the Settlement of Investment
Disputes was created in 1966 to provide conciliation and arbitration
facilities for disputes between governments and foreign private
enterprises. 


         PROPOSAL SUGGESTING
         STATUTORY CHANGES TO
         APPLY SPECIFIC BANKRUPTCY
         PRINCIPLES MUST OVERCOME
         MANY CHALLENGES
------------------------------------------------------ Chapter 4:2.4.2

Another proposal suggested that the U.S.  Sovereign Immunities Act be
amended in a way that, in essence, would apply the cramdown principle
of U.S.  bankruptcy law to sovereign default situations.  Generally
speaking, the act currently allows creditors to sue a foreign state
for default on its debt payments where the state has waived its
sovereign immunity or where the suit relates to the state's
commercial activity.\16 To eliminate the possibility of future
lawsuits, this proposal suggested that the act be amended to render a
foreign state immune from suit by creditors while a restructuring
plan was being negotiated by a majority of creditors or after their
acceptance of the plan. 

Proponents of this proposal have maintained that a new legal
framework could facilitate workouts within the United States because
the threat of lawsuits or other pressures from dissenting creditors
would be eliminated.  Also, they contended that amending the act
could facilitate restructuring by preventing a small minority of
creditors from holding up a negotiated settlement.  However, critics
have said that implementation of this proposal faces serious
obstacles because all major creditor countries would have to adopt
appropriate changes to produce the desired effect universally.  This
consensus could be difficult to accomplish because numerous countries
have different laws, legal traditions, and legal philosophies. 


--------------------
\16 The pertinent provisions of the Sovereign Immunities Act are
contained at 28 U.S.C.  sections 1602-1610.  In general, the act sets
forth the conditions and circumstances under which U.S.  courts have
jurisdiction over lawsuits against foreign states, their agencies,
and instrumentalities.  Among other things, the act allows for such
lawsuits where sovereign immunity has been waived and where an action
relates to the foreign state's commercial activity in the United
States or outside the United States (when such activity causes a
direct effect in the United States). 


         CERTAIN BOND COVENANTS OR
         A PERMANENT BONDHOLDER
         COMMITTEE COULD APPLY
         BANKRUPTCY PRINCIPLES
------------------------------------------------------ Chapter 4:2.4.3

Two proposals suggested ways that capital markets could establish
mechanisms to change conditions of debt contracts so that creditors
could accept a reorganized repayment plan, should a country be faced
with debt-servicing problems.  Specifically, the proposals encouraged
(1) the establishment of a standing bondholder committee or
committees and (2) the revision of certain bond covenants.  With
respect to the latter proposal, covenants that generally require
unanimity would be revised to provide that a qualified majority of
creditors could make changes in the payment terms and conditions of
bonds, thus facilitating workouts. 


      ESTABLISHING BONDHOLDER
      COMMITTEES
-------------------------------------------------------- Chapter 4:2.5

One proposal suggested that a representative bondholder committee or
committees be established to facilitate negotiations between
bondholders and debtor governments when the latter fail to pay
principal or interest according to the bonds' original terms and
conditions.\17 Such a committee would avoid a proliferation of
committees,\18 resolve conflicts among classes of bondholders, and
appoint representatives to negotiate with bankrupt governments to
restructure their debts.  Such a committee might contain permanent
and temporary members, representing large bondholders, mutual funds,
pension funds, and other market participants, and could be modeled
after similar committees, such as the London Club.  In addition, the
proposal suggested that the governments of the major creditor
countries may want to recognize a single, standing international
bondholder committee.\19 The proposal suggested a specific charter
for this committee that would specify the committee's operations, a
set of conventions, a core of permanent members, a permanent
secretariat, and an appointed representative to conduct negotiations. 
The proposal stated that, under certain conditions, IMF could play a
role in helping such a committee reach its goal by providing
temporary liquidity during the restructuring process that could be
repaid as part of an agreement to a final restructured payment plan. 


--------------------
\17 "Symposium--The New Latin American Debt Regime--Towards a
Sovereign Debt Work-out System," Journal of International Law and
Business, Rory Macmillan (Volume 16, 1995) and Crisis?  What Crisis? 
Orderly Workouts for Sovereign Debtors, Barry Eichengreen and Richard
Portes (Jan.  1996). 

\18 In the past, multiple committees, with diluted bargaining power,
negotiated with governments over bond issues.  These committees
competed against one another for subscriptions and commissions. 
Bondholders hesitated to subscribe to the services of a committee
because they were aware that competition reduced the likelihood of
successful negotiations.  Committee organizers had an incentive to
maximize their commission, rather than the return to bondholders. 

\19 There are historical precedents for such mechanisms in the United
States (i.e., the Foreign Bondholders Protective Council, which was
created in 1934 and closed its doors in the 1980s) and the United
Kingdom (i.e., the Corporation of Foreign Bondholders, which was
created in 1868). 


      BONDHOLDER COMMITTEE EFFECT
      ON MORAL HAZARD UNCLEAR,
      ALTHOUGH UNLIKELY TO STEM
      CONTAGION
-------------------------------------------------------- Chapter 4:2.6

Criticisms of the proposal to create a bondholder committee for
international bonds include that such a mechanism would create moral
hazard for countries that issue sovereign bonds.  The critics assert
that creating a mechanism to specify how the bonds would be
restructured could provide more incentive for countries to default on
principal and interest payments than having no mechanism at all. 
However, proponents of bondholder committees do not concede this
point.  They say that the consequences of debt-servicing problems for
a country are so severe (e.g., possible loss of access to
international capital markets) that the existence of a bondholder
committee would not provide an incentive for debtor countries to
announce that they are having debt-servicing problems. 

Because bondholder committees have historically taken a long time to
reach agreement on how sovereign bonds should be restructured, the
committee would neither diminish contagion effects on other
countries' financial instruments nor forestall systemic risk to the
financial system.  A bondholder committee may not contain contagion
effects because creditors could still rush for the exits.  Defenders
of a standing bondholder committee respond by saying that the
existence of a mechanism to resolve sovereign debt arrears could
eliminate some of the uncertainty that leads to contagion and damage
to the financial system. 


         COMMUNICATION AND BURDEN
         SHARING COULD IMPROVE
------------------------------------------------------ Chapter 4:2.6.1

Proponents of a bondholder committee say that burden sharing could be
fairer, depending on the extent to which different types of creditors
are represented on the committee.  Also, supporters say that burden
could be more appropriately shifted from creditor country taxpayers
to the creditors themselves.  One opponent of the committees
responded that the mechanism may have trouble overcoming the
diversity of bondholders.  For example, such a mechanism would likely
not appeal to mutual fund managers who have a short-term perspective
and who often prefer to sell bonds that are not performing as
expected.  A bondholder committee could improve coordination and
communication between parties in a crisis because of the committee's
attempts to minimize uncertainty about the locus of authority in
negotiations.  In addition, administrative burdens could be minimized
because such committees could be developed, based on previous
experience with existing institutions, such as the London and Paris
Clubs.  According to critics, the committee would not have the power
to induce policy adjustments in debtor countries that would make the
country less vulnerable to a future financial crisis. 


         ESTABLISHING BOND
         COVENANTS THAT SPECIFY
         HOW DEBT-SERVICING
         PROBLEMS ARE TO BE
         RESOLVED
------------------------------------------------------ Chapter 4:2.6.2

Another proposal incorporating the cramdown principle suggested that
specific covenants be included in sovereign bonds to facilitate
potential future workout situations.  The market could then lead the
way to ensure that creditors and debtors agree, before a bond is
issued, on specific repayment conditions should a country be faced
with a potential debt-servicing problem.  The proposal suggests that
specific covenants could address issues such as:  how majority voting
would take place to alter the terms and conditions of the debt
contract (usually, unanimous consent of bondholders is required to
change core bond covenants); how objections from creditors or debtors
would be handled; and how payments should be shared among
creditors.\20

We were told that some Eurobonds governed by English law already have
qualified, majority-voting clauses.  The G-10 supported the idea of
establishing bond covenants and reported that the private sector
could take the lead in establishing such covenants with official
sector support as appropriate. 


--------------------
\20 One report noted that to make such covenants palatable to
lenders, dissenting creditors should have recourse to an arbitral
tribunal.  The proposal also noted that such clauses may be easily
implemented because a form of bond covenants already exists. 


         MORAL HAZARD AND
         CONTAGION
------------------------------------------------------ Chapter 4:2.6.3

Proponents of establishing these bond covenants pointed to several
advantages that they say the covenants would convey in resolving
future sovereign financial crises.  They believe that such bond
covenants could speed up the process of debt restructuring and could
therefore limit the potential for contagion effects.  Bond covenants
could limit the ability of some creditors to stall or block the
resolution process because they agree to abide by majority rule on
possible repayment terms.  However, bond covenants, unless they are
activated extremely quickly, may be unable to stem the contagion
effects of other emerging market countries.  With regard to moral
hazard, the G-10 reported that market participants believe that these
covenants might increase moral hazard on the part of the borrower and
consequently reduce the financial instrument's attractiveness for the
investor community.  Other experts say that bond covenants would not
create or enhance incentive for countries to default on their bonds
since no country wants to risk the possibility of losing access to
international capital markets. 


         BOND COVENANTS COULD
         IMPROVE BURDEN SHARING,
         BUT COULD ALSO RAISE
         COSTS FOR SOVEREIGN
         BORROWERS
------------------------------------------------------ Chapter 4:2.6.4

Bond covenants that specify debt-servicing problem or default workout
procedures to resolve potential liquidity crises may foster
cooperation between creditors and debtors.  In addition, bond
covenants could provide for appropriate burden sharing between
debtors and creditors because conditions could be agreed upon to
ensure that creditors are treated and paid in a fair and equitable
manner.  Market participants who were critical of this proposal told
us that bond covenants might raise the costs for sovereign borrowers
because investors are likely to demand a higher premium as
compensation for the inclusion of covenants in bond contracts.  Some
said that, if this happened, debtor countries might resist including
these covenants in their bonds.  Moreover, the G-10 reported that
market participants believed that such covenants could reduce the
attractiveness of emerging market bonds, which are usually viewed as
simple securities that are easily transferable, unencumbered, and
easily sold at any time the investor chooses.  In addition, these
bond covenants could pose unique administrative challenges because
market participants believe it might be difficult to agree on the
terms and conditions to be included in such covenants.  For instance,
market participants reported that they would be unlikely to agree to
conditions that allow nonunanimous decisions by bondholders to change
the schedule of debt payments.  They also rejected that idea of
majority voting clauses because they are viewed as infringements on
creditor rights. 


OUR CONCEPTUAL FRAMEWORK FOR
ANALYZING INITIATIVES AND
PROPOSALS TO RESOLVE SOVEREIGN
FINANCIAL CRISES
=========================================================== Appendix I

We developed a 10-point conceptual framework to guide us in
identifying the advantages and disadvantages of initiatives and
proposals to resolve future sovereign financial crises.  As part of
our analysis of the initiatives and proposals, we sought to determine
whether and how each could

(1)limit contagion and systemic risk to the international financial
system, including responding to a crisis with sufficient speed and
quantity of resources;

(2) affect moral hazard;

(3) induce appropriate country economic and financial policies;

(4) address the cost-effectiveness associated with development and
implementation;

(5) share burdens between parties in a sovereign financial crisis;

(6) facilitate coordination and communication between parties in a
crisis;

(7) be flexible enough to deal with various types of financial
crises;

(8) apply principles consistently to countries in similar financial
distress;

(9) address the legal requirements needed for development and
implementation; and

(10)apportion the administrative burden of development and
implementation. 

In developing the framework, we drew insight from the following: 
interviews with public and private sector officials, the list of
desirable features that resolution strategies should have as
developed by a G-10 Working Party, and our past work.\1 We then
informally circulated a draft of our framework to obtain comments
from officials representing our congressional requester; Treasury,
the Federal Reserve; private capital market participants (commercial
banks, investment banks, and mutual fund managers); academia; and one
private research organization.  Almost all of the officials generally
agreed with the elements of the framework.  However, in a few
instances, some officials made suggestions to clarify some points
within individual elements.  Where appropriate, we incorporated these
comments to finalize the conceptual framework that we used in our
analysis. 

As agreed with our congressional requester, we used our framework to
identify advantages and disadvantages of initiatives and proposals to
resolve future financial crises as they related to the U.S. 
government; U.S.  private sector creditors; and, to the extent
possible, debtor countries.  We assessed information obtained from
published reports and studies and from interviews with U.S.  and
international public and private sector officials. 

In our analysis, we highlighted the framework elements that were most
important to the initiative or proposal being discussed, and we then
divided our analysis into two sections.  First, we assessed the
trade-offs between two issues that were relevant to almost all of the
initiatives and proposals:  (1) the impact on contagion to other
countries and systemic risk and (2) the impact on moral hazard. 
Second, we evaluated the other criteria as relevant to each
initiative and proposal.  For example, one initiative involved
doubling GAB, which are lines of credit that G-10 countries maintain
through IMF, to $47.6 billion.\2 Our discussion of this initiative's
advantages and disadvantages to the United States focused on the
three most salient framework elements:  how the initiative responded
to contagion effects, how the initiative addressed moral hazard, and
how the initiative could spread the burdens for resolving crises.  In
this case, our analysis of GAB did not focus on, to name two, the
administrative or legal requirements elements because neither were
major issues or major obstacles to implementation of this initiative. 

We did not use the framework to endorse any particular initiative or
proposal.  Furthermore, the relative importance of each element in
our framework is a matter of perspective. 


--------------------
\1 Farm Bill Export Options (GAO/GGD-96-39R, Dec.  15, 1995). 

\2 See chapter 4 for more information on this initiative and our
analysis. 


IMF'S SPECIAL DATA DISSEMINATION
STANDARD
========================================================== Appendix II



   (See figure in printed
   edition.)



   (See figure in printed
   edition.)

Source:  IMF. 




(See figure in printed edition.)Appendix III
COMMENTS FROM THE DEPARTMENT OF
THE TREASURY
========================================================== Appendix II




(See figure in printed edition.)Appendix IV
COMMENTS FROM THE BOARD OF
GOVERNORS OF THE FEDERAL RESERVE
SYSTEM
========================================================== Appendix II


MAJOR CONTRIBUTORS TO THIS REPORT
=========================================================== Appendix V

GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C. 

Susan S.  Westin, Assistant Director
Patrick S.  Dynes, Senior Evaluator
Becky K.  Kennedy, Senior Evaluator
Desiree W.  Whipple, Communications Analyst

NATIONAL SECURITY AND
INTERNATIONAL AFFAIRS DIVISION,
WASHINGTON, D.C. 

David T.  Genser, Evaluator-in-Charge
Thomas Melito, Senior Economist

OFFICE OF THE GENERAL COUNSEL,
WASHINGTON, D.C. 

Paul G.  Thompson, Senior Attorney

*** End of document. ***