Contents

I. Introduction

1. The Board has discussed on a number of recent occasions the possible use of precautionary arrangements in capital account crisis prevention.¹ While Directors have strongly supported the objective of promoting crisis prevention, fundamental differences of view exist on the means for doing so, in particular over the need for and desirability of a policy on exceptional access under precautionary arrangements.

2. This paper provides a status report and proposes directions for future work. It begins with an outline of the broader context of crisis prevention and Fund policies. It notes the broad consensus among Directors on the nature of the problem and the areas of agreement on existing Fund policies. It then summarizes the main arguments for and against a policy on exceptional access under precautionary arrangements to help prevent crises. The arguments are grounded in alternative interpretations of available evidence on crisis prevention, particularly pertaining to moral hazard, and the different points of view are in large part due to different weights put on the potential benefits and risks of such a policy. At the heart of these differences lie difficult empirical questions for which unambiguous evidence is limited and likely to remain elusive. Recognizing the lack of consensus among Executive Directors, the final section proposes directions for future work that would include assessments of alternative proposals for country insurance against capital account shocks.

II. Background and Points of Agreement

3. The debate on a crisis prevention and Fund financing has been framed by three main stylized facts:

• Increased external vulnerabilities come with the process of integration into global capital markets. International capital flows can help countries to reach and sustain high levels of investment necessary to promote rapid rates of growth and economic development. However, as countries increasingly tap international capital markets, they inevitably increase their exposure to sudden stops or reversals in capital flows.
  
  
• A country's own economic policies are the primary line of defense against these vulnerabilities. Structural and balance sheet vulnerabilities, as well as inconsistent macroeconomic policies and inappropriate exchange rate regimes, have played a role in triggering and amplifying past capital account crises. Addressing these weaknesses is essential for crisis prevention and should be done early on, before self-reinforcing negative confidence effects take hold and capital account pressures build.
  
  
• Sound policies and effective surveillance do not immediately eliminate vulnerabilities, leaving a role for insurance. Even a country with fundamentally sound economic policies and balance sheets, but with a high degree of integration into international capital markets, still faces a risk that capital account pressures could transform into a self-fulfilling run on its currency. Hence, there is a role for insurance provided by foreign exchange liquidity. Many members have self-insured by building up large international reserves positions, or have sought private contingent lines of credit. Fund resources constitute another source of insurance. As discussed below, however, views differ as to whether Fund membership in itself should be seen as providing sufficient insurance to members.

4. There is broad agreement on the Fund's objectives to help member countries in crisis prevention. First, the Fund should promote the early adoption by members of sound economic policies and strong regulatory regimes designed to reduce their vulnerability to sudden capital outflows. Second, the Fund should provide assurances both to its members and to market participants of its readiness to provide financial support, including above the normal access limits where warranted, in support of an appropriate policy response should a crisis occur.

5. There is also broad agreement on the importance of the wide range of measures that the Fund has taken to improve its surveillance tools for crisis prevention. Policy initiatives include (i) ongoing vulnerability assessments; (ii) the enhancement and dissemination of international data standards; (iii) more disciplined and transparent assessments of debt sustainability; (iv) further work on tools to better assess balance sheet weaknesses; (v) greater emphasis on financial sector surveillance including through the Financial Sector Assessment Program; and (vi) steps to improve surveillance in program countries.

6. Regarding the Fund's financial support, Directors recognize that the experience with regular precautionary arrangements (i.e., those within the normal access limits) has been very positive. The benefits to members include: (i) incentives to adopt better policies; (ii) a commitment device for policy discipline, which can help the member implement its economic program and improve the credibility of its policies; and (iii) an unambiguous Fund seal of approval, which can help catalyze other sources of financing.

7. Finally, Directors support strongly the Exceptional Access Framework. A key objective of this framework is to enhance the clarity and predictability for both members and markets of the Fund's response to capital account crises, while also strengthening the decision-making procedures for considering requests for exceptional access. At the review in April 2004, most Directors felt that the four exceptional access criteria remain appropriate, and the new procedures for decision making were working well.

III. Is there a gap in the Fund's toolkit for Crisis Prevention?

8. Views differ on whether a policy on exceptional access under precautionary arrangements would strengthen further the Fund's crisis prevention efforts. A possible new policy would involve specifying when exceptional access could be used in a precautionary setting and could also include one or more of the following (which have been put forward in previous Board papers): (i) modifications to the structure of precautionary arrangements (e.g., more upfront phasing, more continuous availability of resources); (ii) a modification of the Supplemental Reserve Facility (SRF) to permit use of its resources when a member has only a potential balance of payments need; and (iii) a new name to distinguish the policy from regular precautionary arrangements.

9. One perspective is that existing Fund policies are adequate. This view emphasizes that the quality of a country's own economic policies is the most important factor in reducing vulnerability. The main arguments are:

• Fund membership itself provides insurance. The Fund has a track record of quickly providing support to members hit by capital account crisis (e.g., Korea in 1997). The Fund has formal emergency procedures, which allow an arrangement to be brought to the Board in an expedited time frame. Moreover, the Exceptional Access Framework is designed to give additional clarity on when and how exceptional access could be provided.



• Regular precautionary arrangements can support strong policies. Moreover, such a precautionary arrangement can always be augmented if a crisis occurred. Exceptional access up front would not increase the incentives for members to adopt strong policies.



• A new policy with large, front-loaded access could undermine incentives to undertake reforms (debtor moral hazard), or reduce investors' incentives to evaluate risk fully (creditor moral hazard).



• Innovations to Fund surveillance are bearing fruit. These innovations (paragraph 5 above) coupled with improvements in market differentiation across different sovereign borrowers, have reduced the risk of contagion.



• Current policies do not preclude the possibility of exceptional access in a precautionary arrangement:² Precautionary arrangements with exceptional access could be helpful for members with outstanding use of Fund resources above the normal limits as they are exiting from use of Fund resources, as in the recent case of Brazil. However, some Directors have raised questions about how to define an "exit strategy." Also, some would prefer that SRF resources be used in such circumstances which would require a modification of the SRF decision.³

10. The alternative perspective sees an important role for a new policy on exceptional access in precautionary arrangements. This view sees a gap in the Fund's tool-kit left by the expiration of the Contingent Credit Lines in late 2003. A new policy would help to fill this gap by enhancing the Fund's ability to meet its crisis prevention objectives in the following way:

• It would provide increased assurances of the availability of Fund resources. An explicit commitment of Fund resources with specified conditions when those resources could be drawn would provide greater assurances to the member and markets of the availability of Fund financial support than the implicit assurances associated with Fund membership.
  
  
• It would provide access more in line with potential need. Although major uncertainties exist in estimating a member's potential balance of payments need, past experience shows that in a capital account crisis gross financing needs are very large. Moreover, a member's quota-the metric used for access decisions-may not always adequately reflect a member's balance of payments need.
  
  
• It could reduce the probability of a crisis. The risk of moral hazard needs to be weighed against the risk of a crisis. Higher levels of access and greater assurances could make Fund resources a more effective supplement to a member's reserves and stronger support for the early adoption of preventive reforms, thereby reducing the risk of a crisis.
  
  
• It would enhance incentives for members to adopt strong policies. Some members that are vulnerable to capital account crisis may be reluctant to approach the Fund if the financial support on offer seems minor compared with the potential balance of payments need. The stigma is likely felt most keenly by members whose overall economic policies are already quite strong. Similarly, such a policy may help encourage members to adopt reforms that may entail short-term risks, but have positive effects over a longer run.

11. Both perspectives recognize the risks associated with exceptional access in precautionary settings, but differ in their assessments of the importance of these risks as well as the benefits. In addition, those who favor a new policy point out that many of the risks discussed below also apply to existing Fund instruments. Some risks depend on how widely the new policy would be used, which in turn can be affected by the design of the policy. Risks include:

• The Fund may be reluctant to send a negative signal that a program has gone off-track. Concerns that a delay in completing a review may send a negative signal to markets, thereby undermining confidence and precipitating a crisis, could cause the Fund to grant waivers, tolerating policy slippages.
  
  
• Excess financing could be provided in situations that call for more adjustment. A large and automatic first purchase under such a policy could allow the member to delay needed policy adjustments unduly in response to balance of payments pressures.
  
  
• The Fund's own resources could become overstretched. Committing significant Fund resources to members in precautionary settings would reduce Fund liquidity, possibly constraining the ability of the Fund to respond to an actual crisis. This problem could be worsened if members were reluctant to exit from use of the new policy, weakening the revolving nature of the Fund's resources. Conversely, some proponents have argued that to the extent a prevention policy successfully reduced the incidence of crises, fewer Fund resources would be tied up in costly and lengthy crisis resolution, strengthening the Fund's ability to respond to a crisis.

12. Underlying the differences in the assessments of the risks and benefits are difficult questions for which decisive empirical evidence does not yet exist and more experience is needed. These questions include: (i) does higher access to Fund resources affect the probability of a crisis, and does the impact depend on the country's circumstances and policies; (ii) how important is moral hazard, are the debtor or creditor channels more crucial, and how does a precautionary policy that involves exceptional access change moral hazard materially; and (iii) do access levels and Fund conditionality affect incentives to implement strong policies?

13. Several operational questions have some bearing on the assessment of the cost-benefit tradeoff of a high-access precautionary policy:

• How to measure potential balance of payments need? Decisions on access under precautionary arrangements would be based on an estimate of the country's potential balance of payments need. Such estimates are particularly difficult to make when the potential need relates to the capital account since capital outflows in a crisis can have several possible sources (e.g., reversal of inflows, deposit outflows, liquidation of domestic assets). However, measuring potential balance of payments need may not be more demanding than projecting actual need during a capital account crisis.
  
  
• What criteria should be utilized? Most Directors agree that it would be inappropriate to provide exceptional precautionary access to members whose main vulnerabilities are in the current account, those with large macroeconomic imbalances or structural and balance sheet weaknesses, or with poor records of macroeconomic policy. On the other hand, during the review of the Contingent Credit Lines some Directors felt that its eligibility criteria might have been too restrictive.
  
  
• Causes of balance of payments need? There is also broad agreement that crises triggered by a member's own policy slippages should be excluded from automatic coverage under such a policy. Hence, the policy would need a mechanism to ensure a sound policy footing, such as the traditional quantitative conditionality used in precautionary arrangements. Further consideration would be needed on whether or not to exclude exogenous current account shocks.

IV. Conclusions and Next Steps

14. It is unlikely that the differences in Directors' views can be bridged with a detailed policy proposal at this stage. Many differences relate to fundamental issues pertaining to the role of the Fund, and difficult empirical questions balancing the benefits and risks associated with exceptional access. A convergence of views appears unlikely, at least until more information becomes available on the main tradeoffs, and more experience has been gained with existing policies. At that time, staff could return to work further on the outstanding operational issues noted above.

15. Existing Fund policies provide some support for crisis prevention. The Fund stands ready to provide rapid financial assistance to the extent possible to members should a capital account crisis occur. The exceptional access criteria are designed to provide clarity to both members and markets on the conditions for such assistance. The Fund's surveillance tools have enhanced our capacity to advise members on emerging vulnerabilities at an early stage. The Fund will continue its efforts to sharpen its surveillance so that, should a crisis occur, the transition from surveillance to a Fund arrangement is more predictable for the member and markets.

16. There seems to be sufficient interest among Directors to continue the exploration of financing mechanisms to help prevent crises. Looking ahead, if Directors agree, staff could step back and consider the feasibility and tradeoffs of possible alternative approaches to providing country insurance against capital account shocks. Existing research in these areas remains somewhat preliminary, making it difficult to gauge their operational potential at this stage. However, staff could, for example, assess the pros and cons of reserve pooling arrangement proposals, under which members could voluntarily pool some of their existing reserves for use by the participating member countries in the event of a capital account crisis. Use of these resources could be linked, formally or informally, to a Fund monitoring mechanism or the use of Fund resources. Staff could also examine the feasibility and the costs and benefits of the development of markets for new contingent instruments to help countries hedge macroeconomic risk.⁴ Another possible direction is to examine the extent to which the design of Fund facilities encourages country insurance, or the adoption of prudent macroeconomic policies more generally, including outside the framework of a Fund program.⁵