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					                BANK OF CANADA

Prevention and Resolution of International Financial Crisis:
                   Work in Progress

                        Remarks by
                     Gordon Thiessen
               Governor of the Bank of Canada

                          To the
           Reinventing Bretton Woods Committee
                     Montreal, Quebec
                     23 October 2000
           Prevention and Resolution of International Financial Crisis: Work In Progress

It is a pleasure for me to be in Montreal today to speak to this conference on, “The Governance of the
Global Capital Market.”

Let me first review some of the lessons that I believe we have learned from recent events in terms of crisis
prevention. I then want to move quickly to the area where the outstanding issues remain - the framework
for crisis resolution.

Crisis Prevention: Some Lessons Learned

There was no single cause of the severe economic and financial difficulties experienced by Thailand,
Malaysia, South Korea, Indonesia, Russia, and Brazil in the financial crisis of 1997-98. What we saw, in
various combinations, were large and growing current account deficits, excessive reliance on short-term
borrowing, overvalued fixed exchange rates, weak domestic financial systems, and a lack of transparency
in financial positions.

In addition, there was what you might call a chain of guarantees that appeared to provide protection to
both borrowers and lenders. These included fixed exchange rates, implicit or explicit government
guarantees to financial and non-financial corporations, and the possibility of international bailouts. These
guarantees distorted market incentives and encouraged large inflows of capital into these economies. In
the end, more funds poured in than, in a number of cases could prudently be invested.

Now, two years later, what can we say about the lessons from these events? First, there is broad
agreement that the best defense against financial crises is establishing sound macroeconomic
fundamentals and having a credible policy framework that can deal with economic and financial shocks.
In particular, fiscal policy must be on a sustainable track, supplemented by a monetary policy focused on
low and stable inflation.

The choice of exchange rate regime is another crucial part of a sound macroeconomic framework. A
common feature of the emerging market crises in the late 1990s, as well as Mexico's in 1994-95 was the
lack of adjustment of fixed or quasi-fixed exchange rates in response to economic circumstances. As a
result of these events, there is a growing body of evidence that traditional pegged exchange rate regimes
are particularly susceptible to speculative attacks and, ultimately, are probably unsustainable.

To avoid this, countries with open capital markets have essentially two alternatives when it comes to
choosing a viable exchange rate regime for the long run. They can choose either a flexible exchange rate
(combined with a domestic anchor for monetary policy, such as an inflation target) or a firmly fixed
exchange rate under a currency board or through the adoption of a common currency.

I do not, however, want to rule out the possibility of using a fixed, but adjustable, exchange rate as a
temporary measure while major economic corrections are being undertaken in a country and while there
is a lack of confidence in monetary and fiscal policies. But this should be seen as only a temporary
solution, and some sort of exit strategy is needed.

Another significant lesson from the recent financial crises is how in most countries, the magnitude of the
problem was exacerbated by weak banking systems. The international community is now giving
considerable attention to strengthening the financial systems in emerging economies and to improving
risk management in creditor banks in major industrial countries. A report last year by the Basle
Committee for Banking Supervision the international group that has taken the lead in this area - highlights
the need for clear and conservative accounting standards and for strong corporate governance.

A broad international consensus has also emerged on the importance of prudent asset-liability
management, with a particular focus on the balance sheets of governments and the financial system. Of
course, prudent government debt management starts with a fiscal policy that is on a sustainable track.
Beyond that, care must be taken to avoid excessive reliance on short-term borrowing, particularly in
foreign currency, and to avoid the “bunching” of debt- service payments. Moreover, governments must
consider their contingent claims, such as sovereign guarantees of private sector debts.

Given these lessons, considerable work has been done by international groups to establish globally
accepted codes and standards of best practices. The international community has established a list of 12
key codes and standards for sound financial systems. While the establishment of international standards
is a major step, it is also vital that we develop the means for assessing adherence to these standards. One
of the enduring lessons of the Mexican and Asian crises is the importance of increased transparency Not
only does better communication on a timely basis help investors adjust to new information more
smoothly, it also reduces the risk of contagion. The IMF has introduced standards for the dissemination of
data on output and prices, fiscal and external accounts, as well as on international reserves and liquidity

Progress has been made in all these areas and global financial markets have taken note. Capital flows are
returning to the emerging-market economies, and far more attention is being paid to assessing risk and
pricing credit than before the Asian crisis. The importance of these capital flows cannot be stressed
enough. Developing countries need long-term access to capital to help them grow and develop. This can
best be accomplished by ensuring their access to world savings through open capital markets. The steps
being taken in response to the recent international financial crises are designed to improve and strengthen
our market-based global financial system. It is essential that these international efforts continue so that as
many countries as possible can experience the benefits.

Crisis Resolution: A Way Forward

Even with all these preventive measures in place, however, crises are still likely to occur from time to
time as a result of sharp economic shocks of one type or another When this happens, national
macroeconomic policies must be adjusted in response to the shocks. However, such adjustment often
takes time. If policy is not credible, and if the market is impatient, then the prospect of adjustment may
not be sufficient to restore confidence in the short-run in these circumstances, there may be a strong
incentive for lenders and investors, both foreign and local, to pull their funds out of the affected countries.

Such an exodus of funds can lead to financial crises -- staying put would be in the collective interest of
both lenders and investors. There has been intense debate about what should be done to address this
collective action problem and to help resolve crises once they begin. At one end of the spectrum, some
have suggested that the IMF should provide emergency liquidity assistance in potentially unlimited
amounts. The IMF should, in effect, become an international lender of last resort. Alternatively, some
commentators believe that official finance is part of the problem. Thus, they recommend that IMF lending
be abolished and that creditors and debtors should handle the fallout of any crises themselves.

I do not find either of these extremes palatable. From my perspective, turning the IMF into an
international lender of last resort is impractical. Unlike a domestic central bank, the IMF cannot create
liquidity. It therefore lacks the resources to stem large speculative attacks. This is just not a viable option
Moreover, unlike a domestic regulator; the IMF cannot change the management of a country it deems
insolvent. Nor can a country be reorganized in the way the domestic authorities can deal with an insolvent

The other extreme -- a world without official finance would ensure a maximum of private sector
involvement in crisis resolution. However, in such a world jittery markets could deprive countries of the
time needed to adjust to shocks. This would be a world of sharp swings in output and frequent and
possibly disorderly, payment interruptions, with adverse consequences for third parties. Such an outcome
would be in the Interests of neither the creditors nor the debtors.

What we need to find is a middle way between these two extremes - a middle way that offers a workable
solution with proper incentives to bring creditors and debtors together quickly when problems arise. We
at the Bank of Canada, working together with other international colleagues, are looking to develop a
framework and a set of tools that the international community can use to encourage borrowers and
creditors to renegotiate debt-solutions in an orderly fashion despite the often-tumultuous circumstances of
a financial crisis. While each financial crisis is different and will require case-by-case responses, a more
predictable framework would greatly help in making decisions about those responses.

Common sense suggests that a more predictable framework for crisis resolution would be better than a set
of ad hoc arrangements. If, for example, creditors do not have a way of gauging what will happen if debt
needs to be restructured, they simply cannot properly assess the risk attached to the credit. And if they
cannot assess risk, they cannot price the credit properly. In other words, a more predictable framework
provides some basis for private sector decisions. A more predictable framework also guides expectations
during crises, and it provides a mechanism by which borrowers and lenders can be brought together

This need for a more predictable framework has become much more important with the growth of bond
finance in emerging markets. In past crises, international banks were often the major creditors. And in
most cases, it was possible to get the major players around a table and seek to negotiate a solution. This
is unlikely to work in the future since a crisis country's bondholders may number in the thousands. We,
therefore, need a framework that will help to encourage the coordination of a large number of creditors
when crises arise.

One of the tools needed for creditor coordination already exists but is underused. I am thinking of
collective-action clauses. These are contractual arrangements that allow holders of an affected country's
bonds, to more easily coordinate their involvement in debt restructuring. The Government of Canada
recently announced its intention to put collective-action-clauses in its international bond issues to help
pave the way for other countries to do so. Let me quickly add that providing more predictability in crisis
resolution is not just a matter of the official sector articulating a framework for private sector
involvement. It also requires the official sector to carefully consider its own role in crisis management
and ensure that its involvement contributes to this predictability.

Clarity about the size of official assistance and the terms under which it will be made available during
crises is essential to encourage the private sector to become involved early in the resolution of crises.
Since we do not have an international lender of last resort that can provide unlimited funds, we must
accept that official finance will be limited. Greater certainty about the limits on official lending would
provide a much clearer basis for effective planning by both creditors and debtors.

A logical consequence of limited official finance is that there will be times when standstills will be
needed to provide a breathing space during which debt service can be rescheduled. By “standstills” I
mean a temporary suspension of debt service payments to help sort things out. Standstills and the
presumptions about limits to official finance are two key issues that require further discussion, debate,
and analysis. Let me take a moment to outline our thinking on both of these issues.

Standstills should not be construed as a way of relieving debtors of their obligation to service their debts.
Rather, I see them as a crisis management device that offers two benefits. They can promote creditor
coordination. An orderly standstill can break the circuit of destabilizing, and ultimately self-fulfilling,

creditor fears in times of crisis This can be an efficient way of forestalling a liquidity run by encouraging
creditor coordination. Standstills can be a positive-sum game, advantageous to debtors and creditors alike.

Standstills can also align incentives. As a backstop for dealing with crises, standstills provide incentives
for creditors to reach voluntary agreements with debtors, and for debtors to take remedial policy actions
more promptly. Some have argued that by including standstills in the framework for crisis resolution, we
will encourage investors to “rush for the exits” at the first sign of trouble. I am not convinced that this
will happen. Investors with a short time horizon will always want to get out fast, regardless of the
institutional arrangements in place. However, consider the situation for “relationship lenders,” who
usually hold their investments longer. With a credible, well-managed standstill as a backstop, their
incentive to race the short-term investors to the exit could well be reduced

In addition, standstills can help ensure that liquidity problems do not translate into solvency problems. I
think the effect of providing some assurance to relationship lenders at least mitigates and perhaps more
than offsets-the negative consequences arising from the behavior of skittish short-term investors. Another
concern regarding standstills is that they will lead to contagion. There are three channels by which a
standstill imposed by a major debtor country could affect other countries. First, investors could hedge
their position by reducing their exposure to “similar” countries. Second if investors are levered, a
standstill could lead them to sell off their exposures to other countries so as to meet margin requirements.
Third, the imposition of a standstill could lead to a flight to quality.

The key point here is that all these channels operate not only when standstills are imposed, but also when
a major debtor country is in crisis and doesn't impose a standstill. The question is whether contagion
would be amplified if there were a well-defined framework for standstills. In the face of a liquidity
problem, a country could short circuit the collective action problem by quickly imposing a standstill. We
would then expect less contagion. This is because, by resolving a pure liquidity problem, no investor
would ultimately be faced with losses.

Finally, let me go back to the limits on official financing in crisis resolution. I believe that definite limits
on official finance would improve the incentives for both creditors and debtors to find a prompt resolution
in a financial crisis. However, one can never rule out the possibility that dramatic events could occur that
would require exceptional international action. There is, therefore, a need to find the right balance of
rules and discretion - what a central banker would call “constrained discretion.” The issue is how to
preserve the incentives and credibility of a coherent framework while maintaining the necessary degree of

One approach that merits consideration would involve clearly identifying those circumstances that would
justify a departure from the normal limits on official finance. This could be combined with a defined
process for taking such a decision and a post-event audit. These three ingredients – a statement of
objective, clearly defined responsibilities, and after-the-fact accountability - seem to me to provide good
governance arrangements for the extremely difficult decisions that would need to be taken in the face of a
major crisis that threatened international financial stability.


My objective today has been to identify and address some of the key outstanding issues with respect to
the prevention and resolution of international financial crises. These issues require further analysis,
discussion, and debate. I believe that we all want to find a credible, workable framework in which the
hard judgments that inevitably have to be made can be made most effectively. There are no easy answers
here. But we must all continue our efforts at finding workable solutions.