FISCAL CONSERVATISM, EXCHANGE RATE FLEXIBILITY, AND THE NEXT…

   FISCAL CONSERVATISM, EXCHANGE RATE
 FLEXIBILITY, AND THE NEXT GENERATION OF
                DEBT CRISES
                                 Kenneth Rogoff

   Despite all the invective hurled at international financial markets
by critics of the "Washington Consensus," the fact is that strong
healthy financial markets are essential for middle-income countries
that aspire to the ranks of advanced countries. Deeper financial mar-
kets mean a better allocation of risk, but they can also make econo-
mies more vulnerable to crises. The question is not simply how to
avoid crises entirely, but how to handle the ones that do inevitably
occur. When it comes to avoiding international debt crises, the single
best precaution any middle-income country can take is to keep down
its debt/GDP ratios, especially public debt, and especially public ex-
ternal debt. The second most important step is to adopt a sufficiently
flexible exchange rate regime. Whereas relatively fixed exchange rates
systems work well for poor developing countries that are insulated
from international capital markets, they are a lightening rod for dis-
aster for upper-middle-income and advanced countries, except per-
haps for economies headed toward a currency union.

Lessons from the Recent Debt Crises
   There is little question that overly rigid exchange rate regimes
played a central role in virtually every major international debt crisis
over the past decade. Mexico (1994), Thailand and Asia (1997­98),
Russia (1998), Brazil (1999), and Argentina (2001) all fell into debt
crises under the weight of unsustainable fixed exchange rate regimes.
As Obstfeld and I wrote in our 1995 paper "The Mirage of Fixed
Exchange Rates," countries with open capital markets are very

  Cato Journal, Vol. 25, No. 1 (Winter 2005). Copyright © Cato Institute. All rights
reserved.
   Kenneth Rogoff is the Thomas D. Cabot Professor of Public Policy at Harvard University and
former Chief Economist at the International Monetary Fund.


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seldom able to maintain fixed rates for more than half a dozen years
without experiencing a major crisis.
   Many economists (e.g., Jagdish Bhagwati, Dani Rodrik, and Joseph
Stiglitz) lay the blame for the 1990s debt crises on premature capital
market liberalization, and there is an important element of truth to
this. But it would be far more accurate to say that the real problem in
the 1990s was that Asian economies liberalized their capital markets
without simultaneously making their exchange rates more flexible.
Had they done both simultaneously, most if not all of the crisis-
stricken countries would still have experienced a crisis, but the prob-
lems would likely have been smaller and easier to manage. One can
point to many reasons why New Zealand and Australia did not col-
lapse in the same way as other Asian economies, including better
financial market regulation. But during the European Monetary Sys-
tem crisis of the early 1990s, Sweden had reasonably strong and well
regulated financial markets, but this did not protect it from catastro-
phe when speculators challenged its exchange rate peg. I have little
doubt that Australia and New Zealand would have met the same fate
but for their very flexible exchange rates.

Vulnerability to Future Crises
   Will the world be less vulnerable to crises over the next decade
than it was over the preceding decade? There is good news and bad
news. The good news is that outside Asia, and excluding central Eu-
ropean countries that are hoping to join the euro system, few coun-
tries today have rigid exchange rates. Brazil can certainly thank its
flexible exchange system for helping it to survive its 2002 crisis, to-
gether, of course, with prudent domestic macroeconomic manage-
ment and $30 billion in back-loaded IMF loans.
   But there are also several reasons for concern. First, what about
countries that are still pegging? Investors seem confident that Central
European countries will not have crises on their way to joining the
euro, though it is hardly obvious why these countries should be im-
mune to the problems that beset "Old Europe" in the early 1990s.
Indeed, one can make the case, as did Ken Froot and I (1991) that
risk of crisis can actually rise as a country's date to join currency union
grows near. And then, of course, there is Asia, and especially China.
These countries have slipped back into the quasi-pegs that got them
into trouble in the late 1990s. The difference, today, of course, is that
many Asian countries have vast reserves of dollars. But many Euro-
pean countries, too, had ample reserves in the early 1990s, but that
did not stop them from being stared down by speculators. If local and

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global investors lose confidence in a government's willingness to sus-
tain a currency peg, skyrocketing interest rates can break a country's
banking system and investment, and force even a financially well-
armed government to back down and surrender (see Obstfeld and
Rogoff 1995). I see no reason to believe that Asia's reserves will
protect them any better today than Europe's reserves helped in the
early 1990s.
   It is curious that many of those who call for a more flexible ex-
change rate in China do so because they believe the yuan will appre-
ciate and that stronger Chinese currency will help shore up the gap-
ing U.S. current account deficit. If so, they are greatly exaggerating
the effect. Most models (e.g., Obstfeld and Rogoff 2004) suggest that
the effect would be relatively marginal. (Recall that Japan's exchange
rate appreciated steadily throughout the 1970s, 80s, and 90s without
making a big dent on its surplus.) That said, having more flexible
exchange rates in Asia will provide a cushion if the U.S. current
account were suddenly to implode, a distinct risk.
   But the real reason why China should move now toward a more
flexible exchange rate sooner rather than later is that exit from a fixed
rate is far easier when the pressures are for appreciation. If, instead,
China waits until it experiences a political or financial crisis, it may
find all the pressures going the other way, and managing a soft de-
preciation under pressure can be extremely difficult.
   Another source of concern is that whereas many parts of the world
now have more flexible exchange rates, both public and external debt
levels remain at record highs, even after the good policies in many
countries over the past year. The IMF's World Economic Outlook
(September 2003), for example, showed that average public debt
levels in developing countries actually exceed those of OECD coun-
tries, despite much lower tax rates, and despite the fact that these
countries often experience severe debt dynamics when debt levels
exceed 50 percent of GDP, much less than Maastrict treaty levels of
60 percent. Another serious problem is the still high level of dollar-
ization and indexation of debt, again despite the fact some countries
have been moving to take advantage of current benign conditions to
lengthen the maturity of their debts and to reduce indexation (see
Reinhart, Rogoff, and Savastano 2003). Brazil's 2002 crisis came de-
spite a flexible exchange rate, in large part due to the fact much of its
debt was short term and indexed to the dollar, effectively taking away
the option of inflation as an alternative to outright default. Indeed, in
many ways, Brazil's flexible-rate crisis in 2002 may be the quintes-
sential early 21st century debt crisis, as opposed to Mexico's 1994
crisis, which looked more like an old-fashioned fixed-rate collapse.

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   Finally, another major cloud hanging over the global horizon is the
gaping U.S. current account, whose inevitable adjustment is likely to
lead to a sharp drop in the dollar, the consequences of which could
easily be increased stress on emerging markets. Obstfeld and I re-
cently recalibrated our Jackson Hole (2000) paper in which we first
drew attention to the problem of the U.S. current account. Our new
analysis, which takes into account the global general equilibrium ef-
fects of a U.S. current account collapse, suggests a 50 percent larger
fall in the dollar than we had thought previously (Obstfeld and Rogoff
2004).
   So, one must conclude that whereas things are better than a decade
ago in some dimensions, in other ways, things are worse. What can
countries do to mitigate their risks?

Avoiding Future Sovereign Debt Crises
   Some lucky countries may be able to solve their problems through
a political marriage. Spain, Portugal, and Greece, three long-time
serial defaulters, have seen marked improvements in their interest-
rate spreads over the course of the last 20 years, thanks to the Eu-
ropean experiment. Countries in Central Europe today are hoping to
do the same. Otherwise, countries must do as Chile has done over the
last 20 years, or as the United States and Australia did in an earlier
era, and bring public debts down to very low levels for a sustained
period. Unfortunately, short of an up-front debt restructuring (which
may not be such a crazy strategy for some countries, although right
now the timing would be very poor), few countries have the political
fortitude to run the kind of surpluses needed to replicate the Chilean
experience. Doubly so since emerging market debts, both public and
external, are still at record levels.
   So, in all likelihood, we will still see more major debt crises within
a few years, either in Asia where de facto fixed exchange rate regimes
still rule, or in Latin America, Turkey, and a few other emerging
markets, where debt levels are still high, and debt is too highly in-
dexed to simply inflate it away. What can the international financial
community do to prepare for this eventuality?
   Many different ideas have been advanced. Some have argued that
with a bit of financial engineering to help countries borrow in their
own currency, the problems can be solved, and countries will be able
to borrow even more. I am quite dubious that financial engineering
solutions can cure deep-seated political economy and development
problems in middle-income countries.
   Another approach is to recognize that collapses will occur and debt
restructurings will be necessary in some cases, but that we need to

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find more efficient ways of dealing with them. In 2001, the IMF, led
by First Deputy Managing Director Anne Krueger, endorsed the idea
of an international bankruptcy court. The idea of bankruptcy court
had been widely discussed in journals since the early 1980s (Rogoff
and Zettelmeyer 2002), and had been popularized by Jeffrey Sachs in
the mid-1990s. There is great merit to this basic idea of improving
international legal coordination over bankruptcy proceedings, and I
would venture that some movement in this direction is likely over the
next 50 years. (Although I expect the scheme that the world ulti-
mately evolves to will be more decentralized than was envisioned in
the IMF proposal.) For now, however, a bankruptcy court of any type
is not in the cards politically.
   Another idea is to reverse legal changes made during the 1970s that
made it easier for countries to issue debt under New York, London,
or Tokyo courts (Bulow and Rogoff 1989, 1990). Rescinding these
changes would work to "level the playing field" for equity and direct
foreign investment. The idea would be to force debtor countries and
foreign investors to rely on debtor-country institutions for enforce-
ment of debt contracts, as is already largely the case for equity and
direct foreign investment. In the short run, capital flows would likely
contract, but in the long run they would resume in a healthier form
with better risk-sharing properties, because countries that desire to
borrow would have incentives to improve their own legal systems. In
all likelihood an international bankruptcy court, were one ever estab-
lished, would have a very similar effect of leading to an initial con-
traction in debt flows relative to equity and direct foreign investment.
   So far, officials have only tinkered with the system, introducing
majority action clauses into new bond issues, so that rogue creditors
have a harder time blocking debt restructurings. This is a small posi-
tive development, but contrary to claims, unlikely to have more than
a marginal effect, not least because each country issues many differ-
ent bonds. Debtors and creditors have also been working to establish
a "code of conduct." This is another small positive step. Still, all this
tinkering feels a bit like the many interim updates of Windows soft-
ware that Microsoft keeps offering PC users. The changes do not
seem to make much difference to the operation of the system, and it
still is going to crash periodically.

Reshaping the IMF and the World Bank
   This leaves a final question, which I can only touch upon here: how
to reshape the International Monetary Fund and its sister institution
the World Bank. Though most discussions start and end with the

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IMF, I think the clearer course is with the World Bank. As Bulow and
I argued in 1990, and as I argued again recently (Rogoff 2004), it is
high time to financially restructure the World Bank so that it contin-
ues its excellent work but as a pure grant-making agency, rather than
as a "bank." When the Bank was formed after World War II, one
could make a case that a multilateral official creditor was needed to
substitute for missing private markets. Today, however, this is an
absurdity and leads to the bizarre situation in which the World Bank
Group makes loans to countries like China and Russia, both of whom
have hoards of reserves and extensive access to private markets. In-
stead, the Bank's future in middle-income countries lies in its role as
a repository of development ideas and advice, and in its excellent and
broad-ranging professional staff. Changing the Bank's financial struc-
ture will help avert problems such as in Argentina, where the Bank
was pouring money in the late 1990s at just the time Argentina most
needed to rein in its belt.
   Deciding now to change the financial structure of the Fund is more
difficult. I have long favored having the Fund phase out of the bailout
business. In the long run, this seems inevitable. With the explosion of
private markets, the Fund's most important role is in its so-called
surveillance capacity, and in providing a secretariat for global finan-
cial leadership. In crises, it can still play a central role even without its
own bailout funds by coordinating the international response. To
maintain the strength of the Fund, it is important that any financial
restructuring leave it with ample resources to cover its operation costs
without relying on the whims of politicians. It would also be desirable
to strengthen the independence of the executive board that oversees
the Fund, and recalibrate voting shares to be consistent with today's
world.


Conclusion
   Improving international financial governance will help the system,
but the real responsibility lies with developing country governments.
Those that adopt rigid exchange rate regimes or engage in excessive
borrowing are going to eventually run into problems under any in-
ternational system.


References
Bulow, J., and Rogoff, K. (1989) "A Constant Recontracting Model of Sov-
  ereign Debt." Journal of Political Economy 97 (February): 155­78.

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          (1990) "Cleaning Up Third-World Debt without Getting Taken to
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Froot, K., and Rogoff, K. (1991) "The EMS, the EMU, and the Transition to
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International Monetary Fund (2003) World Economic Outlook (September).
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