Saving the International Financial System in 1997

The indispensable role the G-7 played in preventing the 1997-8 Asian currency crisis from becoming a systemic threat, and containing it in ways that extended the democratic and market principles within Asia, provides further momentum for the Birmingham meetings. The G-7 can be faulted for not focussing adequately on the looming crisis at the Denver summit in June 1997. At Denver, G-7 finance ministers devoted considerable time to financial regulation, but they and their leaders had lost the sense of urgency generated by the Mexican peso crisis and assumed the existing Halifax measures would suffice. The leaders were also too preoccupied with welcoming Yeltsin as an all but full member of the club in return for his acquiescence in the enlargement of the North Atlantic Treaty Organization (NATO). This left little time for a serious discussion of Asian financial concerns. 10 The comforting thought that the latter issue was being well managed, and should be managed, by G-7 finance ministers was contradicted by the rational for the G-7's creation, by its historic contribution to devising a durable replacement for the Bretton Woods system of exchanges rates destroyed in 1971, and by the proliferation of the Asian currency crisis over the next six months. Finance ministers do not have the necessary political standing to induce the leaders of South Korea, Indonesia, and other Asian countries to confront their difficulties, abandon long-standing practices, and begin making painful adjustments or to assess the wider economic, political, and military implications of an uncontained crisis.

Primarily because the European members saw Thailand as a regional Asian responsibility, the G-7 played only a passive supportive role at the outset of the crisis when, in August 1997, the IMF made available a US$17- billion package for Thailand. Among the G-7 members, only Japan provided national funds. The finance ministers did make an important collective contribution at their September meeting, held on the margins of the International Monetary Fund assembly in Hong Kong. The Asian currency crisis dominated the G-7 finance ministers gathering, generated a broad review of how the G-7 should best deal with it, and once again placed issues of international financial systems management at the forefront of G-7 attention. 11 Meeting both separately and as part of the IMF Board of Governors, the finance ministers made several historic decisions (none of which had been agreed to at Halifax in 1995). These were to increase the IMF quota share by 45 per cent; to amend the IMF Articles of Agreement within the year to make the IMF responsible for capital account liberalization; to strengthen IMF involvement in banking and financial sector reform; to improve national governance by reducing the corruption that comes with crony capitalism; and to increase the allocation of special drawing rights (SDRs). At Hong Kong the G-7 was also able to dissuade Japan from its concept of a regional support fund and to make clear that the IMF must remain at the core of any rescue effort.

Together the Hong Kong reform package provides clear evidence of the value of the G-7 as a concert of equals - a forum in which different members could take the lead and prompt an otherwise recalcitrant United States to adjust to a new and globally effective consensus. On the IMF quota share increase, the other G-7 members combined to press a resistant but internally divided United States, which feared congressional opposition, to accede at the last minute to a 45-per-cent addition. On capital account liberalization (an issue pioneered by the British and adopted as his own by Michael Camdessus, the managing director of the IMF), early misgivings within Canada blunted initial enthusiasm for a blanket grant of authority to the IMF for unrestricted "liberalization," a move which would endanger cherished national policies (such as national security and cultural security) in many countries. At the Hong Kong meeting of finance ministers, the United States, Japan, and Canada reinforced their initiative, begun at the summit in Lyon in 1996, to emphasize banking and financial sector reform. A strong United States interest in addressing governance issues was supported by Canada and succeeded when the IMF took up the question at Hong Kong. On the SDR equity allocation, the G7 agreed ot double the allocation and to devote the proceeds to the new members of the IMF.

These precautionary measures were joined by increasingly decisive G-7 action as the Asian financial crisis grew. A support package for Indonesia created a "second line of defence" of national funds to be deployed if those of the IFIs were not enough. Both the United States and Japan contributed to these national funds. In November, all other G-7 members met with the United States, Japan, and the Philippines in Manila. Here they agreed to formalize the second line of defence arrangement and to ensure that they had the legislative authority for all to contribute to it.

The precaution was timely. Early in December, the G-7 countries agreed to support a beleaguered South Korea with a package of US$35 billion from the IMF, the World Bank, and the Asian Development Bank, reinforced if necessary by a second line of defence from their own national funds. To this second line Japan contributed US$10 billion, the United States US$5 billion, each of the European G-7 members US$1.25 billion, and Canada up to US$1 billion. As December progressed it became increasingly clear that the international institutions' "first line of defence" was insufficient to deter markets from an attack on South Korean and other currencies. The G-7 began to take decisive initiatives to stem the burgeoning crisis. The immediate trigger for the crisis was a report early in December that South Korea's short-term foreign debt obligations were a formidable US$100 billion, which was much higher than anticipated. The figure was misleading because it was a net figure which did not account for debt roll overs of about US$30 billion or for any of the loans that South Korea had made to other countries and which could be used on a covering swap basis. But it was sufficient to inspire panic within financial markets and for three days in a row the South Korean won dropped by ten per cent, its daily allowable maximum, against the American dollar.

The United States initially hoped that it could save its own dollars for a second line of defence and that making it known that the second line existed would be enough to stop the hemorrhaging. But it soon became clear that a stronger response was necessary. G-7 members secured from their private banks an agreement that the banks would roll over and subsequently reschedule loans to South Korea in return for activating the G-7 member government's second line. This agreement proved to be particularly valuable, given the difficulty the United States government encountered in securing authorization from congress for official funds. G-7 deputies engaged in intensive consultation with one another. Just before Christmas, the IMF managing director convened a gathering with the executive directors of the G-7 countries. The dozen or so individuals present confronted the fact that the IMF's first line of defence was inadequate to stem the cascading South Korean crisis and that they would have to draw upon the second line of defence, composed of the national contributions of the G-10 (the G-7 plus Belgium, the Netherlands, and Switzerland) and some Asian contributors. The American executive director of the IMF called the United States secretary of the treasury, Robert Rubin, who, when appraised of the situation, responded that if American dollars were needed, they would flow. With the United States prepared to commit its share (US$1.7 billion) by 25 December, the others joined in. The announcement on 24 December that national funds would flow was sufficient to stem the tide. 12 The Korean won immediately rose by 22 per cent and its stock market by a similar margin. The agreement of the private banks to roll over South Korean debt was made public on 28 December. The IMF's accelerated $2 billion contribution to the South Korean package came on 30 December.

The G-7's stabilization of South Korea lessened the pressure on the surrounding major currency countries, especially Hong Kong, Taiwan, and China, and reduced the systemic threat of an assault on Japan's precarious financial system. It was those few countries such as Indonesia which resisted the IMF's prescriptions that suffered further speculative attacks, although some others such as the Philippines experienced some collateral damage. As the situation in Indonesia continued to deteriorate, the United States, reinforced by Germany and supported by the G-7, intervened with the Indonesian authorities. On 15 January 1998, the IMF and Indonesia concluded a letter of intent under which Indonesia accepted revised economic targets and more far-reaching structural reform. Although subsequent resistance by the leaders of Indonesia and Malaysia and congressional reluctance to authorize the United States contribution did some damage in the following months, the crisis had been contained by timely, collective G-7 action. In a clear demonstration of the power of the G-7 members over markets, they were able to prevail without employing their national official funds. Instead, they induced the IFIs, banks, and other private-sector actors to provide the required additional liquidity.